March 15, 2013

Low inflation rates are speaking volumes about the economy

Canada’s all-items Consumer Price Index (CPI) in January was only +0.5% on a year-over-year basis, according to Statistics Canada. That was the lowest rate for inflation in this country since October, 2009 (+0.1%).

There were four months earlier in 2009 — June through September — when year-over-year prices actually declined. The nation was in a recessionary tailspin. No one wants to see a repeat of that scenario.

The “core” rate of inflation in Canada in the latest month was +1.0%. That’s a little more acceptable, although still quite restrained. Over the last ten years, the core rate has been lower on only one occasion, in February 2009 (+0.9%).

(The core rate omits eight of the most volatile sub-components of the CPI, mainly in the food and energy categories. Those items are largely outside the control of domestic government policies.)

The comparable inflation numbers in the United States in January were a bit livelier, with the all-items index up 1.6% and the “core” rate ahead by 1.9%.

In both countries, energy prices are dipping (-1.7% in Canada and -1.0% in the U.S.), with the all-important gasoline sub-category also down on a year-over-year basis (-1.8% in Canada and -1.5% in the U.S.).

The fact the inflation rate in Canada is easing is not a good sign. It indicates a sluggish economy. Confirmation of this fact can be found in retail sales. In December, they were -2.1% month-to-month and -0.7% year-over-year.

The Bank of Canada has an official annual inflation target of +2.0%. The Federal Reserve’s hopes appear to be slightly more open, lying in a range of +2.0% to +2.5%.

Some inflation is good for the economy. Deflation is to be avoided if at all possible. When prices drop, consumers hold off spending, waiting for prices to fall further.

The U.S. is currently close to where it wants to be on the price front. In Canada, our central bank would welcome more oomph.

The weakness in Canada’s growth, combined with a low inflation rate, is helping to lower the value of the nation’s currency. That will help somewhat, since it will raise the price of imports.

There are two good questions about prices in general in the U.S. and Canada that I’d like to address in the remainder of this article.

The first is obvious and can be framed as follows. Given that governments around the world — with the U.S. Federal Reserve as the trendsetter — have been “printing money” at a rapid clip, why is inflation remaining so depressed?

This isn’t just a phenomenon in North America. The U.K and the Euro zone have shown only limited price movement. Japan, despite years of effort, can’t seem to light a fire under its CPI. Only India among the larger economies is reporting a conspicuously high advance (+10.6%).

The explanation seems to lie mostly in a lending logjam. The near collapse of the world financial system in 2009 has resulted in several major consequences, one of the most significant being that banks are being required to increase their capitalizations.

As a result, financial institutions have been using newly printed money to build up their reserves. At the same time, they’ve become stingier in granting credit to customers. After all, it was loose lending practices that caused the sub-prime mortgage fiasco, with all its subsequent negative ripple effects.

The fear of freeing up funds, especially in the U.S., has gone too far. The Obama administration keeps trying to persuade bankers to welcome potential customers with more warmth.

Corporations have also been contributing to the liquidity constipation. They’ve been sitting on piles of cash. Since early in the recovery, many firms have been earning strong profits. The proof is in the exceptional performances of the major stock market indices.

But new investments have not been commensurate with the increased cash flows. So-called “treasure chests” are remaining underutilized. Spending on structures has been held back more than on machinery and equipment.

Add to the foregoing that both governments and households have been focused on de-leveraging their finances over the last couple of years. They’ve been obsessed with paying down debt.

What happens when the dam of tight-credit bursts, as eventually it must? Will inflation then skyrocket?

Conventional economic wisdom says it’s a distinct possibility. Given the huge scope of the monetary pump priming that has already occurred (QE1, QE2, Operation Twist, further bond buying that’s essentially QE3, etc.), the world is in unexplored territory and no-one can be sure what the outcome will be.

A second question about inflation asks why prices in Canada remain so much higher than south of the border.

The Standing Committee on Finance of Canada’s Senate in Ottawa recently studied the matter. Its conclusions, plus what pundits in the media have been saying, are as follows.

The average mark-up on consumer goods in Canada versus the U.S. is close to 10%.

Excessive tariffs on some goods imported from offshore are a contributing factor. Ottawa is striving to participate in free trading zones with Europe and the Pacific Rim. But this will likely require deeper concessions than are in place within the NAFTA agreement.

Canada has a number of major industrial sectors that lie under the umbrella of government protection, to one degree or another. Included are telecommunications (with “watchdog” or regulated prices for Internet services, for example), the airline industry, dairy and poultry farming and financial services. Market management usually results in higher prices.

There’s also the matter of economies of scale. Canada has a lower population base that needs to be supplied through relatively longer transportation networks.

It’s also deemed that there is a lower level of competition among retailers and service providers in this nation. There are relatively fewer retailers and service providers seeking to get their hands on consumers’ wallets in Canada than in the U.S.

But circumstances are changing. Increasingly savvy shoppers who conduct price comparisons over the Internet, knowing that they have the option of cross-border shopping, are helping to gradually bring Canadian sellers into line with their American counterparts.

For more articles by Alex Carrick on the Canadian and U.S. economies, please see his market insights. Mr. Carrick also has an economics blog. His lifestyle blog is at www.alexcarrick.com

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