Feeble Inflation Underpins Bank of Canada's Rate-Hike Conundrum

(Bloomberg) -- The Bank of Canada has embarked on what may be the slowest cycle of interest rate increases in more than three decades as it awaits evidence consumer prices are picking up. 

The central bank will raise borrowing costs in October, and then twice in 2018 to bring its benchmark interest rate to 1.5 percent, according to the median forecast of 16 economists in a Bloomberg survey. Ten respondents said inflation risks for monetary policy are now tilted to the “downside,” and the next chance to see whether the data bear that out will be Friday, when the federal statistics agency reports June inflation numbers.

Governor Stephen Poloz flagged the risk of higher inflation as one reason the central bank hiked for the first time in seven years last week. Yet rapid inflation is among the least of Poloz’s concerns, according to the survey. Asked to rank five risks to monetary policy in order of importance, economists put “inflation overshoots” last.

Instead the biggest risk is the opposite one, they said: that inflation remains below target. They flagged a housing correction and U.S. policies that hurt Canada’s economic growth as the second-biggest.

Peak Rate

That means Canada’s policy interest rate will rise more gradually over a longer period, and won’t hit the peak rate -- the level needed to keep supply and demand in balance -- until the fourth quarter of 2019, according to the median forecast, which also pegged the peak rate at 2.5 percent. That would mean the current cycle lasts up to 30 months, compared to an average of less than a year since 1994.

“The Bank of Canada is at risk of raising interest rates too fast due to faith in its models. Inflation has yet to bottom and housing is a big risk,” James Orlando, senior economist at Toronto-Dominion Bank, said in an email responding to the survey.

Poloz raised his policy rate to 0.75 percent on July 12, the first Group of Seven policy maker to follow the tightening of the U.S. Federal Reserve. Poloz said he needs to start moving with inflation set to approach his 2 percent target by the middle of next year as output returns to normal after an energy shock, and future moves will be guided by economic data.

Inflation Scorecard

Poloz will get his first scorecard on inflation trends since the rate increase on Friday at 8:30 a.m. when Statistics Canada reports the consumer price index for June. Pricing information will likely be under heavier scrutiny, and here’s what you need to know:

• The average of the trimmed mean, common, and median core inflation measures -- used by policy makers to analyze underlying trends of inflationary pressures -- was sitting around 1.3 percent as of May, the lowest since 1999. 
• The central bank’s former core measure, abandoned in late 2016 and which excludes eight volatile components and the effects of indirect taxes, is at 0.9 percent, matching the lowest level in the history of the data.

• Economists expect June inflation to rise 1.1 percent from a year earlier, according to the median forecast in a separate Bloomberg survey, down from 1.3 percent last month, which was the lowest reading of 2017. 
• Downside surprises are becoming normal for this indicator. Readings for the annual rate of total inflation have missed median forecasts in 9 of the last 12 releases.

In last week’s Monetary Policy Report, the Bank of Canada explained part of the current softness in overall inflation to be temporarily caused by declines in electricity prices. Prices for electric power have certainly been deflationary in Ontario -- down more than 16 percent from a year earlier after the government introduced rebates. Elsewhere in Canada it’s a different story, where prices are returning to historical averages and have been above headline CPI for the last two months.

Whether inflation gets back to target in about a year as the Bank projects may also depend on its judgment that the big shocks are a thing of the past. Since the global banking crisis struck in 2008 and oil prices slumped in 2014, there have been two periods where it’s taken about two years for the inflation rate to move back above 2 percent after receding below that mark.

To contact the reporters on this story: Erik Hertzberg in Ottawa at eschmitzhert@bloomberg.net, Greg Quinn in Ottawa at gquinn1@bloomberg.net, Catarina Saraiva in Washington at asaraiva5@bloomberg.net.

To contact the editors responsible for this story: Theophilos Argitis at targitis@bloomberg.net, Chris Fournier, Stephen Wicary