If you’ve ever wondered how well the Bank of Canada does its job, check out this chart below from economist Sheryl King.
It shows the trend in Canada’s inflation level back to 1995 (when the BoC started using interest rates as a tool to achieve its 2% inflation target).
(Click to enlarge. Source: The Globe and Mail)
As the chart illustrates, inflation tends to stick near 2%. That’s thanks, in large part, to the BoC’s inflation control mandate.
Long-term, there is no reason to believe the Bank won’t be able to maintain this 2% trajectory. And the suppressing effect that could have on interest rates should be welcome news to Canadian mortgagors.
Of course, rates can and do spike in shorter time periods. Even though inflation ranges from 1% to 3% the vast majority of the time, there are wildcards and one of them is commodity prices. “(Commodities) are always a risk for headline inflation, particularly if global growth starts to reaccelerate,” King told CMT on Monday.
The BoC gets really concerned by inflation that’s outside of its 1-3% range. If price increases threaten to persist in the high 2%, or 3% range, for example, the BoC may aggressively raise rates until economic demand slows and/or supply catches up.
But rates never keep going up. Over the past two decades, when inflation has exceeded one percentage point above target, the consumer price index (CPI) has typically come back down within three quarters (and mortgage rates have come down with it).
(Click to enlarge. Source: Bank of Canada)
A mature low-growth economy (like ours) and an aggressive inflation-targeting central bank are kryptonite to inflation. For that reason, it is highly unlikely that inflation would ever stay above the BoC’s 3% “control ceiling” for several years. Mortgage consumers can take some solace in that.
If long-term inflation continues at 2% as expected, rates cannot run up drastically and stay up. And in the medium term, some are even more dovish. King cites an IMF study saying, “getting prices back up to (the 2%) trend will require a lower policy rate” [italics ours].
All of this implies a reasonable risk level when choosing a shorter term (like a variable, 1-year or 2-year fixed) assuming:
- You’re well qualified;
- You can handle the potential risk of 20-30% higher payments (stress test your mortgage); and,
- The difference between long- and short-term mortgage rates is sufficiently wide (e.g., when short-term rates are over one percentage point below long-term rates).
The above points are worth contemplating if you want alternatives to locking in
for the long haul.
Other facts about inflation:
- The most important measure of inflation is arguably “core inflation,” which measures the underlying trend in consumer prices. The Bank’s preferred measure of that is CPIX. CPIX has averaged just 1.6% in the past 5 years (well below the 2% target), notes King.
- Inflation today doesn’t matter as much as inflation tomorrow. The BoC tries to project inflation 1.5 to 2 years out because that’s how long it takes rate increases/decreases to work their way through the economy.
Rob McLister, CMT
Last modified: April 26, 2014
It should also be noted that CPI is continually going through modifications and you can no longer make a direct correlation between’s todays numbers and those 5 or 10 years ago. There also has been arguments that we are under reporting inflation as the changes have continually given lower results compared to using past methodology . Some have also argued that inflation should be weighted heavier towards the median income, as inflation exceeding wage increases causes significant long term damage to the economies supply/demand balance.
Here is a partial list of recent changes:
http://www23.statcan.gc.ca/imdb/p2SV.pl?Function=getDocumentation&Item_Id=138267
Seriously, you’re looking at a 30-year secular decline in interest rates and think you can draw future trends from it? Now you just look silly.
Many argue the exact opposite, that CPI is overstated due to biases in the methodology.
See http://www.quickmba.com/econ/macro/cpi/
Interesting article and fortuitous timing given the potential collapse of Potash prices. That’s a commodity that impacts food prices and, therefore, CPI.
It seems that there’s just been one more shock that will keep rates low, or even bring them down.
Past comparisons are really inconsequential. The Bank of Canada is tasked with managing inflation based on the current definition, as established by Statistics Canada. Independent bodies like the IMF have certified that definition as methodologically sound and consistent with international best practices. We can quibble about nuances in the calculation but the fact remains, the BOC has a tremendous track record of keeping inflation on target.
Brilliant article Rob – very well done! I love the facts and historical context.
I am not embarrassed to say that I was surprised that there actually was a worldwide price fixing cartel that artificially kept the price of fertilizer high.
I suppose it is a sign of the times that a business website would just nonchalantly mention the unfortunate demise of price fixing group that forced hungry people all over the globe to pay more for food so agri-business giants could make more profits. I am anything but a socialist but I was amazed.
Rob,
Very good article. One thing that concerns me is that several factors that affect prices, wallet and expenditures of Canadians are not taken into consideration for inflation (ex. Gas prices, housing etc).
Comments?
This study may as well have have told us that us it’s probably been dark most nights for the last 20 years.Picking the time frame in which to do an economic analysis invariably has a way of swaying the outcome, and 20years is an insignificant time frame if you want to look at a cycle of inflation/deflation
The last twenty years of mostly stable growth is not a period of time on which to draw this conclusion. Back this analysis up another twenty years to 1973 & take into consideration the first oil crisis, OPEC looming large on the horizon, double digit inflation well into the early 1980’s, government mandated wage & price controls, redo your analysis, and THEN see if you can draw the same conclusion. It is highly unlikely the results will be similar.
Great article but it is tough trying to draw an inference from only 8 years of data. The BoC has always used interest rates to control inflation; it was only in 1995 that they started to use their control almost exclusively as a tool to control inflation. I would like to see the same graph reach back into at least the ’70s to compare interest rates to inflation. I think you’ll find it impossible to make any recommendations regarding short term vs long term mortgages.
Unfortunately CPI/CPIX and inflation targets aren’t the whole picture.
CPI tracks the cost of living by comparing the cost of goods and weighting them by importance. We can debate the accuracy by arguing how they weight it, but for the sake of the argument, let’s say it’s accurate.
The theory is that as long as it stays within the predefined “target” our economy is considered to be growing at a sustainable pace.
The problem is that’s only one side of the story – spending. In order to determine sustainability, we also need to look at where the money is coming from.
Unfortunately, a lot of it seems to be coming from credit. Our debt-to-income just peaked at 165% a few months ago (and thankfully is slowly starting to fall).
Therein lies a pretty obvious problem – when you’re spending 1.6x what you make in order to prop up 1-3% growth target, it’s easy to see our growth isn’t sustainable – it’s all smoke and mirrors.
And while the “solution” thus far has been to decrease interest rates to make it easier to get caught up, all it has done is skew affordability, and it simply hasn’t worked. In fact, it’s made the problem worse – it’s given people access to more credit to keep putting them further into debt.
Statistics are only relevant in context. Saying “inflation is at it’s target, so everything is great” is not only misleading, it’s patently false.
That, and the CPIX takes into account the price of Tobacco (see the link from the article: http://www.bankofcanada.ca/rates/indicators/key-variables/inflation-control-target/ ), even though tobacco is a luxury, not essential, and tobacco use has been on a pretty steady decline over the past 10 or so years. Including that in the “core” inflation number is pretty questionable.
Tracking these sorts of things is hard since cultural attitudes on spending shift over time. As per my other post, all statistics require context to be relevant, otherwise, if we’re misinformed, it could lead us down the wrong path.
Hi Folks, Debating alternate perspectives is the purpose of this forum so thank you for all the feedback. A few comments:
Tom & StatGuy: Agreed.
Gord & Calum: Many thanks for your posts.
David & JSydneyH: Many would contend that the vastly different circumstances of the 70’s/early 80’s make comparisons impossible. Productivity improvements, wide-scale outsourcing, and the Internet are just a handful of important trends that took hold post-1980. Policies and commodity dependence have also changed. The muted effect of record-high $145/barrel oil in 2008 is one example of how the inflation landscape has been altered. The fact remains, Canada did not have an explicit 2% inflation target 30+ years ago and growth was on a different plane. These are only some of the reasons why the last few decades may be more reflective of what’s to come.
Paulo: To your first point, tobacco is not included in core inflation, as measured by the CPIX. Regarding credit use, one could write 100 posts on that topic alone. Suffice it to say, any eventual deleveraging would further support a long-term low-rate theory. On your last point, it is not being asserted that on-target inflation makes everything “great.” There are always wildcards in any outlook, as noted. Inflation control, in this context, is discussed simply with regards to its long-term effect on the risk of choosing a shorter term.
Camilo & Paolo: There has always been debate over the CPI basket, but empirical evidence supports that the CPI, as constructed and over time, is a reasonable representation of overall consumer prices.
Cheers….
Rob
“it is tough trying to draw an inference from only 8 years of data”
check your math
Rob, you only need look at your own link, but I’ll copy and paste it here for reference:
“Core” consumer price index (CPIX):
This measure strips out eight of the most volatile CPI components (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation, and tobacco products), as well as the effect of changes in indirect taxes on the remaining components. The Bank also monitors other measures of underlying (“core”) inflation.
(from http://www.bankofcanada.ca/rates/indicators/key-variables/inflation-control-target/)
I’m open to discussion on this point, but that’s as it reads on the BoC website…
I don’t see how “any eventual deleveraging would further support a long-term low-rate theory.”, if low rates haven’t encouraged any sort of deleveraging. Debt-to-income has steadily increased as rates have gone down.
Great points Ron. Do we really have “free market” enterprise that is weighted equally across the board?
Good response. I find it amusing how some commenters try to come across as knowing more about the CPI than the Bank of Canada and Statistics Canada themselves.
It says it right on the Bank of Canada site: http://www.bankofcanada.ca/rates/indicators/key-variables/inflation-control-target/
“Core” consumer price index (CPIX):
This measure strips out eight of the most volatile CPI components (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation, and tobacco products), as well as the effect of changes in indirect taxes on the remaining components. The Bank also monitors other measures of underlying (“core”) inflation.
—
I’m just using the very information that they provided…
“Strips out” means excludes. :)
Wow! How totally misinformed can you possibly be.
The debt to income ratio does not imply that Canadians are consistently spending 165% of their income on an annual basis; it measures total debt to one year’s income.
Sheesh!
D’oh – misrread that as it uses those exclusively (that is, strips them out for the CPIX)
However, if that’s the case, how can you strip out food, gasoline and interest – a very relevant chunk of a family’s expenses.
He didn’t say “consistently”, and he didn’t say ” on an annual basis”.
Its easy to tear a hole in someone’s post, when you first re-write it…
I never say never but contemplating double digit inflation in this century just seems preposterous.
Any reference to debt to income is useless without a reference to the quality of borrower. It has to be the most abused statistic in the business. Someone with a $100,000 mortgage earning $60,000 a year has a 1.65% debt to income ratio. What does that tell you? Nothing.
You are so correct sir.
Paolo obviously not only doesn’t understand the metric, but then rails against the misuse of stats out of context; and then quotes a metric totally out of context.
Debt service is a far more accurate measures of debt stress than nominal debt. Defaults at near record lows say a great deal.
Paolo is an amateur as evidenced by his obvious comprehension difficulties.
Hey Paolo what does “stripped out” mean again?