Canadian Inflation: Hot or Not?

The Canadian economy just printed stronger than expected CPI readings for August, allowing the Loonie to extend its rally against most of its forex counterparts last week. The core figure showed a 0.5% rebound, higher than the projected 0.2% uptick, while the headline CPI stayed flat instead of marking a 0.1% decline. On an annualized basis, both core and headline CPI are up 2.1% in August.

Components of the report revealed that price increases for telephone and internet access services were mostly responsible for the strong gains in core inflation. On top of that, household items chalked up a 4.4% year-over-year increase while shelter costs were up 2.8% from a year earlier.

Some forex market analysts took this as a sign that the Bank of Canada could start upgrading its CPI forecasts and eventually consider tightening monetary policy, as Canada’s annual inflation rate has been hovering around the central bank’s 2% target since May this year. “The BOC likely will have to upwardly adjust its forecasts and admit that the strengthening economy is also helping to lift inflation,” pointed out Dana Peterson, an economist at Citi Research in New York.

However, BOC Governor Stephen Poloz himself cautioned against these hawkish expectations, saying that market participants shouldn’t get too excited about rising price levels just yet. In fact, he mentioned that the jump in inflation has just been spurred by one-off factors, such as the Canadian dollar’s depreciation.

A quick review of the forex charts indicates that the Loonie has fallen significantly against the U.S. dollar since early 2013 when USD/CAD had been trading below parity. From there, the Canadian dollar steadily lost value until the second quarter of this year.

USDCAD Daily Forex Chart

As we’ve learned in Economics 101, currency depreciation weighs on its purchasing power. This means that you’d need to fork over more cash to pay for the same item compared to when the local currency was stronger. With that, the steady decline in the Loonie’s value has put upward pressure on price levels, thereby boosting inflation for the past few months.

This is why probably why BOC Governor Poloz has been careful not to assume that the latest run in inflation was caused by better Canadian economic performance. “There is excess capacity both in output space and in labor market,” he explained. “We know the Canadian economy has a significant amount of room to grow.”

“The idea is to get the economy back to normal, and then inflation would be sustainably at target, not just accidentally,” Poloz added. With that, the BOC isn’t likely to announce any rate hikes anytime soon, with some forex analysts predicting that the BOC benchmark rate would be maintained at 1% until mid-2015.