Canada’s Monetary Policy May Be Hindering Inflation Fight

Canada’s Monetary Policy May Be Hindering Inflation Fight

Economists at National Bank Financial (NBF) say the Bank of Canada’s method of closely monitoring inflation and determining when interest rates can be reduced must be revised. The BoC’s progress in controlling inflation is not accurately reflected in official data, possibly leading the central bank to implement exceptionally restrictive monetary policy.

According to the study by economists Matthieu Arseneau and Alexandra Ducharme, the Bank of Canada’s favoured indicators for core inflation, CPI-trim and CPI-median, which aim to eliminate the most unstable price categories, are still being influenced by the steep increase in shelter payments, made up of mortgage interest costs (MIC) and rental prices.

NBF Respectfully Disagrees with BoC

Bank of Canada’s Governor Tiff Macklem recently discussed the ongoing impact of price pressures, even if we exclude fluctuating mortgage interest rates and rental price hikes. It’s evident that inflation continues to be a problem, even if we don’t consider the costs related to housing. This means that prices for goods and services are still rising, making it more expensive for people to afford their everyday needs. Inflation can have a significant impact on the economy, as it can lead to higher interest rates and lower purchasing power for consumers.

One way to comprehend this is by examining the preferred metrics for core inflation, such as CPI-trim and CPI-median. These metrics specifically exclude items that experience the most volatility. Since most shelter components fall into items with significant price increases, they are not considered in these core metrics. Consequently, the core metrics reveal an inflation rate of over 3%.

On the other hand, the NBF economists disagreed with the Governor’s assessment, believing that housing expenses make up a considerable chunk (11%) of the overall basket, which significantly influences the core inflation indicators. In simpler terms, these expenditures fill the spot usually held by the items on the higher side of the price spectrum, thus contributing to the inflation rise as indicated by these metrics.

Inflation Metrics Without Mortgage Interest Costs

The rate of headline inflation in March was reported to be 2.9%, according to the latest data from Statistics Canada. This was mainly driven by a significant increase in mortgage interest costs, which rose by 25.4% compared to the previous year. Although this is slightly lower than the rate of 26.3% seen in February, the NBF notes that if mortgage interest costs were not factored into the Bank of Canada‘s consumer price index (CPI) calculations, the overall inflation rate in February would have been just 1.9%, falling below the central bank’s target.

Excluding the impact of interest-carrying costs of mortgage payments and rents, the inflation rate in Canada for February was a modest 1.4%. However, when the shelter costs component is removed entirely, the annual inflation rate drops even further to 1.3%. This suggests that the economy is currently facing an oversupply issue. Despite this economic challenge, the consumer price index increased by 2.8% year-on-year in February, surpassing the target rate of 2.0%.

CPIX versus Current Inflation Metrics

The technique used to calculate core inflation, CPIX, stands out from current methods such as CPI-trim and CPI-median due to its unique process of excluding specific elements in inflation measurement. While both CPI-trim and CPI-median aim to provide a more precise representation of underlying inflation trends by removing extreme values, their methodologies differ.

The CPI-trim method calculates the Consumer Price Index by excluding a certain percentage of the highest and lowest price changes. This means that extreme price fluctuations are not considered when determining overall price changes. By doing so, the CPI-trim method aims to provide a more accurate representation of the average price change.

On the other hand, the CPI-median takes a different approach to calculating the Consumer Price Index. Instead of excluding extreme price changes, it focuses on the middle value or the median price change. This means that it considers the price changes that fall in the middle range and ignores all other fluctuations. The CPI-median method measures the typical or median price change by doing so.

In contrast, the CPIX technique usually excludes specific items or areas that tend to experience unexpected price changes. This is done based on the method employed, which helps customize the CPIX approach. By doing so, the CPIX method eliminates particular well-known inconsistencies in price data.

Other Central Banks Are Already Excluding Shelter Payments

In their study, the NBF economists challenge the exclusion of this component in monetary policy, citing the example of Sweden’s central bank. Since 2017, the bank has opted not to consider the influence of mortgage interest expenses to avoid any direct impact on the targeted inflation measurement. According to the authors, the Bank of England (BoE), European Central Bank (ECB), and US Federal Reserve (Fed) do not face this issue because their targeted inflation measure does not factor in mortgage interest.

Before 2016, the Bank of Canada favoured CPIX as its main inflation gauge. This did not consider mortgage interest costs alongside 7 other unstable categories. The economists argue that CPIX should be reinstated as a primary measure of core inflation. They believe it is a more suitable tool for navigating the current inflationary situation. According to this indicator, underlying inflation has returned to its target level.

In Conclusion

Of course, this is neither the first nor the last study to argue that Canada’s monetary policy should return to using CPIX to assess inflationary pressures, primarily since so much of our economy depends on housing, and supply is limited. At the same time, the country’s population continues to surge.

Financial markets are forecasting the Bank of Canada to start cutting its policy rate this summer, so we’ll see how inflation will continue to affect the forecast for mortgage rates. Suppose you’re a prospective homebuyer or homeowner looking to renew or refinance your mortgage. In that case, we recommend discussing with a mortgage expert how your mortgage strategy could benefit from nesto’s low mortgage rates while the Bank of Canada continues its restrictive monetary policy.