August 7, 2012
June inflation continues to support low Canadian and U.S. interest rates
The rate of general price inflation in Canada increased slightly in June versus May, but remained well below any breakout level that might set off alarms.
The “core” rate of inflation in the latest month was +2.0%. The core rate omits eight items which display out-of-the-ordinary volatility. They’re largely products beyond domestic and/or government control.
Fruit and vegetable prices, for example, can swing wildly depending on weather conditions not only in Canada but in other nations as well.
And energy prices are set internationally. They’re subject to geo-political events in the Middle East and elsewhere.
A core rate of +2.0% is exactly on target with what the Bank of Canada wants to see.
A moderate 2% level of inflation is neither too restrictive nor too stimulatory. But it does act as a lubricating agent for overall economic activity.
For example, it helps consumers and businesses pay back fixed-dollar borrowings. Over time, loan carrying charges for individuals become easier as earnings increase. The same holds true for firms when standard price increases are implemented for the products and/or services they sell.
The two key measures for inflation in Canada in June were within 0.2 percentage points of the same indicators in the U.S. The south of the border was +1.7% year over year and the U.S. core rate (defined as the CPI less food and energy) was +2.2%.
In the latest results, there was more lift from food prices in the U.S. (+2.7% year over year) than there was in Canada (+2.0%).
The energy sub-sector price shift, however, worked in the opposite direction. In the U.S., it declined 3.9% whereas in Canada it fell a lesser amount, -0.8%.
There was the same pattern in the price at the pump. The charge for gasoline in the U.S. was -4.3% year over year in June, but only -1.8% in Canada.
The primary effect of the low inflation rates in both countries is to offer “carte blanche” to the monetary policies of the central banks.
Neither the Federal Reserve nor the Bank of Canada has to be concerned at this time that their ultra-low interest rates are a spur to price increases.
The status quo can be maintained for some time with impunity. The Fed has already announced the federal funds rate will be kept near zero percent until the second half of 2014.
In Canada, much of the speculation now centers on whether or not the “overnight rate” will be lowered from 1.00%. Earlier this year, a move in the opposite direction seemed more likely. But that was when business prospects were brighter. Now our economy, along with the rest of the world, is stuttering.
The BOC’s rate was raised from 0.25% to 1.00% in the summer of 2010. There were three incremental increases of 25 basis points each, where 100 basis points is equivalent to 1.00%.
Is it time to reverse course? Unexpected downward shifts in the value of the Canadian dollar will signal that international currency traders see a possible BOC rate cut on the horizon.
Certainly that’s been the trend of late around the world. Central bankers in Europe, Australia, Israel and China have all lowered benchmark interest rates.
When they’re not cutting rates, they’re buying bonds (e.g., the Bank of England). This is a course of action equivalent to printing money.
The Federal Reserve is also buying bonds, but the net effect is a little different. The Fed’s cashing in short-term paper to buy long-term notes as part of “Operation Twist”.
Since the U.S. is still considered the safest place on earth for investment funds, short-term rates stay low anyway. There continues to be a massive demand for U.S. treasury bills at the front end of the maturity curve. (And remember that a higher demand for the asset lowers its yield.)
Applying the proceeds from selling short-term assets and buying long-term notes lowers the rate on ten-year treasuries. In theory, this provides stimulus for the economy by assuring firms of a low- rate environment over an extended time frame.
None of this is stopping speculation that the Fed may be about to launch a QE3 program (i.e., printing more money like in QE1 and QE2, where QE stands for Quantitative Easing). The longer the U.S. economy remains sluggish, the greater will be the pressure to try anything. Throwing money at the problem is a venerable solution.
Canada is starting to benefit from the same “safe haven” status as the United States, although to a lesser extent, of course. The “float” of Canadian paper is miniscule by comparison.
Nevertheless, due to our outstanding financial performance in the recession, with no major banks going belly up and our governments staying solvent, Canadian bonds have become more attractive to foreign investors. Record amounts of capital are flowing into the country.
As a consequence, the yield (1.60%) on ten-year Canada bonds has fallen to an all-time low.
This has a highly beneficial side-effect. It provides unexpected relief in public sector deficit fights, plus it shortens the time line to bring accumulated debt back within manageable proportions.