Don’t economists eat or drive?

What happens when the price of stuff grows faster than your take-home pay? If it goes on for long enough and/or price increases (i.e. inflation) go through the roof, the basic necessities of life can become unaffordable.

Alternatively, what happens when prices drop and are expected to keep falling? People put off buying those things they think will become cheaper the longer they wait, leading to a self-perpetuating downward cycle of declining prices (i.e. deflation). If that goes on for long enough and/or prices drop through the floor, it can tip the economy into recession and lead to massive job losses.

The importance of price trends makes inflation (or deflation) one of the most important economic indicators on the planet. Inflation has particular importance to the Bank of Canada, which pegs its trend-setting overnight lending rate with the specific aim of returning inflation to two per cent (i.e. the midpoint for its inflation target of between one and three per cent).To keep inflation on target, the Bank raises interest rates to cool inflation (or lowers interest rates to support prices when deflation threatens).

However, prices for some of the stuff included in the overall measure for inflation can bounce up and down like a rubber ball from one month to the next. That can make it tough to know how the fundamental trend for overall inflation is evolving. In practice, that means the Bank can’t look solely at the overall inflation rate as a guide for setting interest rates to achieve its inflation target.

To get a better grip on what the underlying inflation trend looks like, the Bank monitors “core” inflation. The core rate excludes eight things whose prices are notoriously volatile; food and fuel are among them.

The Bank keeps a close eye on core inflation to help achieve its overall inflation target, not as a replacement for it. That’s worth keeping in mind when you hear news about how the Bank sees inflation as being well under control despite a jump in the cost of groceries and/or filling up the tank.

Bank of Canada economists do indeed eat and drive. It’s just that they strip those things out of the equation when gauging where underlying inflation is and where it’s going. Right now, the Bank is comfortable with the inflation trend and is in no hurry to raise interest rates.

As CREA’s former Chief Economist, Gregory Klump provided his views on the state of and outlook for Canadian housing markets to news media, policy makers, and real estate industry stakeholders. In 2017, Gregory celebrated his 25th anniversary as a member of the team at CREA. He’s an avid skier and snowboarder during the winter and a year-round Crossfit enthusiast.

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