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Royce Mendes
Managing Director and Head of Macro Strategy
Weekly Commentary
Pragmatic Instead of Dogmatic
April 5, 2024
The Bank of Canada is at risk of leaving monetary policy restrictive for too long. Doing so could tip the economy into an unnecessary recession. Before the last rate decision, we argued that the central bank’s preferred measures of core inflation were overestimating the true nature of underlying price pressures.
Since the original publication of our work This link will open in a new window., we’ve been joined by other economics groups in pointing out the limitations of using CPI‑median and CPI‑trim as operational guides for monetary policy. Our research, however, remains the most robust and sophisticated method for demonstrating their shortcomings.
We showed how skewness in the underlying distribution of price changes has caused the central bank’s indicators to become biased upward. What surprised most readers was how much of the distribution was exhibiting price changes well below the 2% target, as evidenced by the fat left tail (graph 1).
The way raw CPI‑median and CPI‑trim are calculated causes them to ignore important signals about the underlying trends in consumer prices. Following research conducted at the Cleveland Fed, we adjusted for this bias and found that underlying inflation is probably lower than what the unadjusted measures suggest (graph 2).
To the credit of Governor Macklem, he hasn’t been dogmatic in his defence of the Bank of Canada’s so-called preferred metrics. He’s been open about the need to review the indicators in an effort to ensure that central bankers are doing everything they can to accurately gauge underlying inflation.
In recent communications, policymakers have repeatedly stated that they’re looking at a host of inflation indicators, including CPI ex-food and energy, CPIX and the share of CPI components rising faster than 3%. What they’re looking for is consistency across all these indicators.
The good news is that such uniformity is beginning to reveal itself. The three-month annualized rates of CPI‑median, CPI‑trim, CPI‑ex food and energy and CPIX range from 0.0% to 2.3%. As recently as December 2023, that range was 2.4% to 3.8%. While the share of components with prices rising faster than 3% per year remains elevated at 40%, the share of below 1% is now also roughly 40%, higher than it averaged in 2019. The only fly in the ointment is crude oil prices, which have risen 20% since the beginning of 2024.
Still, as it stands today, central bankers should have more confidence that inflation is on its way back to their 2% target than they had earlier this year. Assuming officials are being forthright in their desire to balance the risks around the economy and inflation, a pragmatic approach would call for the Bank of Canada to begin easing around the middle of 2024.
Doing so in a gradual but consistent manner likely wouldn’t stoke any renewed inflationary pressures, given that rates would still be in restrictive territory until at least 2025. But it would soften the blow from mortgage renewals and business insolvencies, which are both piling up. So while we don’t expect any move in rates next week, policymakers could begin signalling that cuts aren’t too far off in the future.