Investors blindsided as Bank of Canada's key inflation gauge fails

Investors blindsided as Bank of Canada’s key inflation gauge fails

By Julie Gordon and Fergal Smith

OTTAWA (Reuters) – Canadian economists are struggling to find a reliable gauge to track core inflation as large and frequent revisions have eroded the credibility of the Bank of Canada’s key gauge, even as the central bank said it was sticking to its core measures.

The Bank of Canada has three preferred measures of core inflation – CPI-common, CPI-median and CPI-trim. The CPI-common, once touted as the best measure of the economy’s performance, has been subject to repeated revisions since the beginning of this year.

The same revisions show that price movements initially identified as transitory turned out to be transitory at all, highlighting the measure’s ineffectiveness when prices rise rapidly and casting doubt on its value, analysts said.

“I believe the steep upward revisions to the common have made it useless as a policy guide,” said Doug Porter, chief economist at BMO Capital Markets. “He missed the inflation boat early in the year and sent a completely misleading signal to policymakers.”

To estimate core inflation, CPI-common measures all components of the CPI that move together and separates out those that appear to fluctuate due to sector-specific events. In contrast, both CPI-trim and CPI-median work by filtering out extreme price movements.

The CPI-common was almost never revised when inflation approached the Bank of Canada’s 2% target. But with prices rising faster than they have in decades, it is now being revised and re-revised every month.

These revisions occur because the statistical model is picking up more common movement in price, so the entire series must be recalculated each month, Statistics Canada said.

“Essentially, this means that more of the goods and services CPI is moving together or that inflation is now broader than in the past,” the agency said in a statement.


Despite the revisions, the Bank of Canada will “continue to monitor all of our core inflation measures” as it tries to get inflation back to target, spokesman Alex Paterson said.

“One of the reasons the bank uses three different underlying measures is to ensure that we consider different price perspectives when assessing the underlying trend of inflationary pressures,” he said in an email.

Governor Tiff Macklem is scheduled to deliver a speech on the current economic situation on Thursday, followed by a press conference.

Three core measures were introduced in 2017 to replace the CPIX, which is a measure of headline inflation excluding the eight most volatile components of a basket of commonly used items.

A 2019 Bank of Canada analyst report, which assessed the performance of seven key indicators from 1992 to 2018, said the CPI-common is the “least volatile” and appears “less susceptible to revisions and sector-specific shocks”.

However, it was developed at a time when inflation rarely deviated from the Bank of Canada’s 1%-3% control range. Inflation has been above 3% for 17 months and was at 7.0% in August.

With the usefulness of the CPI-common now in question and the likelihood of a recession rising, the central bank should take a hard look at how it tracks core inflation, analysts said.

“The bank’s challenge is to walk an extremely fine line between tightening enough to bring inflation back to target and not tightening enough to cause a major recession,” said Stephen Brown, chief Canadian economist at Capital Economics.

Some analysts say the Bank of Canada should revert to the CPIX or simply monitor how many components of the index are growing faster than the 2% target.

Others argue that inflation excluding energy and food is the best measure because it is easy to explain and is similar to how the United States measures underlying price pressures.

“The BoC needs to address how it has overcomplicated core inflation and what measures it is pursuing,” Derek Holt, head of capital markets economics at Scotiabank, said in a note.

(Reporting by Julia Gordon in Ottawa and Fergal Smith in Toronto; Editing by Deepa Babington)

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