Inflation reaches Bank of Canada target, but credit growth still slowing
August 23, 2019
Erik Fertsman
Bank of Canada reaches its goals
Over the last three years, the Bank of Canada has repeatedly seen inflation levels hit its 2 percent target. But now, credit growth has been slowing in consumer and real estate loans, and there's a risk that the consumer price index (CPI) could get sucked back down toward zero as consumers spend and borrow less. Here's the latest data:
The Bank of Canada has an inflation target of 2 percent. There's no real sophisticated reason for setting 2 as the target, but it's done and we've reached it. As you can see on the chart above, CPI (orange line) has made numerous advances above the target. Looking closely enough, we can see that CPI is trending up. This has been good news for the bank, and will likely be a reason for Steven to hold off on any interest rate cuts.
However, pay attention to the light blue and grey lines. The first line is nominal GDP and the second is nominal credit growth among commercial banks. These variables have been trending downward since the summer of 2017. Coincidentally, this was the same time housing price growth started to decelerate across Canada. There's now a risk that a decrease in GDP-related and debt-led spending could throw a wrench into the inflation equation, and start dragging it down back toward zero (deflation).
Canada depends a lot on imported goods, and as I've covered
previously, inflation in Canada has been supported by a depreciating Canadian dollar in the foreign exchange market. So, for Canadians, imported goods have become more expensive, and that's helped push up inflation. This is less a result of the Bank of Canada's work than it is about the value of the loonie set in international markets. So far, a weaker loonie has helped offset the borrowing and spending deceleration in consumer statistics, by boosting prices of imported stuff. But, how long will this last?
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Let's take a closer look at CPI to get a better idea of what's driving what:
Often, inflation is observed by omitting some key items which tend to be quite volatile, like food and energy. When we exclude these items, we can see that inflation is hovering around the same trend as the CPI for all items.
CPIs which exclude shelter or mortgage costs have proven to be more volatile over time. And if we look at the latest CPIs that excludes those variables, you will see how they're coming in lower than CPI that excludes food and energy. So, clearly we're still facing the some upward pressure on inflation. However, the CPIs excluding mortgage interest and shelter have failed to return close to that 3 percent high posted back in July 2018.
If we're looking at a confirmed lower low, it's bad news for the Bank of Canada because it could be a signal of a downtrend formation in the data, which nobody wants.
Housing statistics are starting to fall
One of the other most obvious places to look when it comes to dissecting the CPI, is household related items. We can now see inflation weakness in the home owner inflation statistics. See the chart below:
CPI for the "owned accommodation" category measures all sorts of things that home owners spend their money on (mortgages, home replacement, insurance, etc.). Based on the data above (teal line), inflation has declined for this category down to 2.48 percent from a 2.85 percent high recorded earlier this year. There's now a bit of downside to the data.
If you line up this data next to mortgage credit growth and nominal GDP growth for the "owner-occupied dwellings" category, you begin to see how some of the borrowing and spending weakness around housing may now be starting to show in the CPI. "Owned accommodations" makes up 16.8 percent of the CPI index - it's one of the biggest categories you can find within the basket weights used to calculate overall inflation.
It shouldn't really come as a surprise, either, as we've been watching home price growth come grinding to a halt. This has been led by mortgage credit growth deceleration, and so interest rates have dropped as a result. Lower interest rates generally leads to lower mortgage costs, so you get at least a partial drop in prices for items measured under the "owned accommodations" in the CPI.
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Rental statistics are hovering near 3 year highs
The rental market, on the other hand, has been experiencing stronger than normal inflation as folks struggle with housing affordability, and getting a mortgage. A lack of rent controls together with limited rental supply across cities in Canada is also putting upward pressures on rental prices. Check this out:
CPI for "rented accommodations" normally hovered around 0.6 percent before the summer of 2017 when we saw home price growth start to decelerate. And since then, we've had CPI growth for the category jump by over 100 percent. Now, rental inflation is up to 2.47 percent year-over-year. Meanwhile, there's some support in the form of personal loan credit growth, which some folks may be tapping into to help pay for their rental accommodations.
Unlike the other categories of GDP we saw in the previous charts, which are trending downward, GDP in the rental market is stable. However, rented accommodations only forms a small 6.59 percent of the CPI basket, so it's unlikely to really prop up the larger inflation indexes that the Bank of Canada and economists watch. It does reveal what's going on in the overall "accommodations" categories: the rental category is up, while the ownership category is down.
Consumption goods are at risk of reversing inflation
Two categories which are trending upward and form over 15 percent of the CPI basket are food purchased from stores and water, fuel, and electricity. Check it out:
These two categories are pushing up the overall inflation index since the summer of 2017. Food purchased from stores, alone, makes up 11.31 percent of the CPI index. Most food is imported, meanwhile credit card quantities have also increased over the period, which might be providing some additional support on food prices. But this variable is often excluded from the inflation calculation.
The next two largest categories, household operations (9.37 percent of basket) and private transportation (17.57 percent of basket) are not doing so hot. Both are now down below the 2 percent target, and appear to be trending downward this year. Meanwhile, GDP for service-producing industries is starting to get pulled down, as well.
What this means for the Bank of Canada
Inflation has been a central bank obsession since forever. Back in the 1970s, there was too much of it. Now, there's too little. Above, the data shows us that there's a lot of downside risk to prices, which, if triggered, would throw things into a deflationary doom-loop. This needs to be avoided.
Plenty of voices on the Internet and on more traditional forms of media are still scared of inflation. They'll tell you to buy gold and bitcoin, because there's going to be a loss of trust in fiat currency. This is not a fear that haunts central bankers in advanced economies these days. The idea that central banks are good at stoking inflation is sort of dead.
Canada's central bank, like others, is mandated to achieve "price stability," but it's not the kind that fights off inflation. No, it's been on an "inflation-targeting" mission to prop
up consumer prices to fight off deflation - the new threat haunting central bankers.
Deflation is terrible for the economy because prices shrink and the currency becomes worth more over time. This is a problem for businesses and consumers, as it means paying back those consumer and commercial loans will cost more and become harder. As a result, further credit creation slows as businesses and consumers fear a strong currency. This is what makes deflation such a huge problem; it creates a doom-loop where no credit equals no growth, and no growth equals no credit.
You wouldn't want to get a mortgage in a currency that grows stronger ever year - it will cost more than getting a mortgage denominated in a currency that depreciates. So, deflation transmits strongly into macro outcomes: deflation erodes credit creation and constrains spending on transactions that get recorded in GDP.
Unfortunately, it's not clear if the Bank of Canada understands this, and I'm afraid they're not going to understand what needs to be done to get out of this situation.
Cover image source: Nathalia Segato
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