Sunday, August 30, 2020

That sinking feeling: Canadians losing faith in price index and that has central bankers worried
MAGICKAL THINKING
Kevin Carmichael:
If we think prices are rising, they probably will, 
which means interest rate hikes sooner than BoC wants

Author of the article:Kevin Carmichael

Publishing date:Aug 26, 2020 • 

The Bank of Canada is in the middle of a major review of how it sets interest rates. 
PHOTO BY CHRIS WATTIE/REUTERS FILES

The Bank of Canada is starting to worry about inflation.

Not because it sees any, mind. The Consumer Price Index (CPI), in which the central bank insists that it still has confidence, suggests inflation is non-existent. The CPI rose only 0.1 per cent in July from a year earlier, suggesting deflation is a bigger risk than runaway prices.

That sinking feeling: Canadians losing faith in price index and that has central bankers worried

Still, Carolyn Wilkins, senior deputy governor at the Bank of Canada, conceded in a speech on Aug. 26 that a growing number of Canadians are losing faith in the CPI and therefore in the central bank’s assurances that inflation is under control.

That matters because there is a self-fulfilling element to cost dynamics: If we think prices are rising, they probably will. And if the central bank can’t control expectations, it might have to raise interest rates sooner than it would like in order to stay within range of its inflation goal, which at the end of the day is its only job.

“There is one area where we need to dig in more. That is the measure of our inflation target,” Wilkins said. “Many people feel that inflation is higher than reported.”

Wilkins’s comments are the clearest signal yet that policy-makers think they could have a problem on their hands that is separate from the immediate concern of facing down the COVID-19 recession.




The Bank of Canada is in the middle of a major review of how it sets interest rates. While holding consultations last year, it discovered that a critical mass of Canadians think the CPI is an abstraction that has little connection to their daily lives. The lockdowns exacerbated the problem, as shopping patterns shifted dramatically. We essentially stopped spending on recreation and travel, and instead bought more at grocery stores. Yet the CPI continued to factor in what was happening with movie tickets and restaurant meals even though those things no longer mattered to people.

“The price of meat has risen by more than four per cent since February,” Wilkins said. “That doesn’t feel like low inflation to me or to many families, yet measured inflation is close to zero when you consider the full basket of goods and services.”

Evidence that the public is becoming skeptical of the way statisticians measure inflation adds a new dimension to the Bank of Canada’s research program.

When policy-makers started thinking about the issues they should explore back in 2017, the emphasis was on whether there might be a better way to set interest rates than targeting an annual two-per-cent increase in the CPI, the Bank of Canada’s approach since the early 1990s.


It’s critical that we measure inflation as accurately as possible so Canadians have confidence in our target
CAROLYN WILKINS

That work is coming along. Rhys Mendes, the central bank’s managing director of international economic analysis, presented at a virtual conference on Aug. 26 an overview of preliminary results of the “horse race” officials are conducting between a set of popular theories on how central banks should conduct monetary policy.

So far, the current regime is performing well. Adding an employment goal to the inflation target also produces positive outcomes, as does a framework that attempts to achieve an average rate of inflation over a longer period of time. Mendes had fewer positive things to say about two other approaches that are popular with academics: price-level targeting, which would require setting interest rates to achieve a specific increase in the CPI rather than a rate of change; and the idea that central banks should target a certain change in nominal gross domestic product.

To be sure, the Bank of Canada’s research so far detects only marginal differences between all the approaches. “I’m not sure the gains would justify shifting away from the current mandate,” said Mendes, who early in his presentation made clear that he was speaking for himself and not Governor Tiff Macklem, Wilkins and the other members of the Governing Council.


The research is primarily based on models, including some that attempt to forecast how the various regimes would affect income inequality. But the Bank of Canada’s economists aren’t relying entirely on their mathematical prowess and the power of their computers. They also conducted human trials in which they explained the various policy regimes in detail and then gave subjects $25 to spend. The idea was to observe what actual people would do with real money based on their sense of how inflation would eat away at their present wealth. The result: mostly irrational behaviour, as participants tended to be more persuaded by “trends” than the calculations of central bankers and statisticians, among other things.

Wilkins pledged to make the CPI more believable. The central bank and Statistics Canada already are working on an alternate inflation measure that has re-weighted the items in the CPI basket to reflect current spending patterns. Last month, the Bank of Canada said the alternate calculations suggested inflation was a little hotter than the official reading, but not so much so that it was ready to abandon the CPI.

At least not yet.

“Last year during our consultations, we heard loud and clear that the measure of inflation needed to be considered,” Wilkins said. “This work continues now at an accelerated pace,” she added. “It’s critical that we measure inflation as accurately as possible so Canadians have confidence in our target; and we must address public perceptions in our analysis and communications.”

Financial Post

• Email: kcarmichael@postmedia.com | Twitter: CarmichaelKevin






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