Introduction to Canada’s Central Bank and Inflation
The Bank of Canada (BoC) recently revealed that it’s considering a major overhaul of how inflation is measured. Deputy Governor Rhys Mendes warned that mortgage costs have distorted the Bank’s preferred Consumer Price Index (CPI) readings. This has led to discussions about whether to scrap mortgage interest or its preferred measures altogether in favor of "underlying inflation."
Canadian Monetary Policy and Mortgage Finance 101
To understand the BoC’s comments, it’s essential to have a quick refresher on monetary policy and mortgage interest. The Bank of Canada’s primary job is to control inflation, keeping price growth near its 2% target using its key tool: the overnight rate. When inflation is low, the BoC cuts rates to encourage debt-fueled consumption and stoke demand. Conversely, when inflation runs hot, rates are hiked to cool borrowing and reduce consumption.
Mortgage rates directly transmit monetary policy through inflation expectations. Variable rates move with the overnight rate, driven by short-term inflation expectations. Fixed rates, meanwhile, track bond yields, which reflect medium-term inflation expectations. In stable economies, those rates converge – short and medium-term expectations should move in sync.
Canada’s Unique Approach to Inflation and Monetary Policy
Canada is unique among advanced economies in its approach to inflation measures. Unlike Europe or the US, Canada includes financing costs, specifically mortgage interest, in its CPI. Because shelter is the largest component of the CPI basket, this design gives mortgage costs disproportionate influence over inflation. This creates a problem, as mortgage interest is determined by inflation itself, leading to circular logic.
The Impact of Mortgage Interest on Inflation
The inclusion of mortgage interest in the CPI has significant implications. When the BoC cuts rates, mortgage costs fall, dragging CPI lower. The downward pressure on CPI then justifies more cuts, inflating home prices with leverage and forcing other CPI components to work harder to offset the drop in mortgage costs. Conversely, raising rates leads to surging mortgage costs, instantly pushing CPI higher, as if higher borrowing costs were the same as economic growth.
The Bank of Canada’s Preferred Core Inflation Measures
The BoC is finally acknowledging the problem exists. Deputy Governor Mendes explained that mortgage interest costs "obscure the broader response of inflation," leading to poorly guided policy decisions. The Bank’s preferred core measures, such as CPI-trim and CPI-median, are designed to filter out volatility from categories like mortgage interest. However, they’re failing to do so consistently.
Rethinking the Inclusion of Mortgage Interest
The BoC is considering revising its preferred measures and alternative measures of core inflation to pre-exclude mortgage interest costs. This move aims to address the issue of mortgage interest distorting CPI readings. However, it raises questions about the Bank’s ability to produce results, despite setting its own target and determining how it measures progress.
The Concept of Underlying Inflation
In a bizarre speech, Deputy Governor Mendes suggested that the BoC is reassessing how it measures underlying inflation, stating it’s not a statistic, but rather a concept that tries to capture the persistent part of inflation related to economic fundamentals. However, he later used underlying inflation as a statistic to justify the council’s recent rate decision, which the BoC has since implied may not be effective.
Conclusion
In conclusion, the Bank of Canada’s approach to measuring inflation is unique and has significant implications for monetary policy. The inclusion of mortgage interest in the CPI creates circular logic, and the Bank’s preferred core measures are failing to filter out volatility. The consideration of revising these measures and the concept of underlying inflation raises questions about the Bank’s ability to produce results. Ultimately, the BoC must carefully reassess its approach to measuring inflation to ensure effective monetary policy decisions.
