Canada’s inflation surge is leaving almost as quickly as it appeared, but it’s not gone yet. BMO Capital Markets wrote to investors this morning, warning the Consumer Price Index (CPI) is about to get a boost from gasoline prices. A base effect that helped to lower the headline CPI growth is about to work in the opposite direction, which will appear as an acceleration of inflation. If the central bank doesn’t navigate the issue carefully, it can turn into an actual problem, requiring higher interest rates.
Base Effects Are Skewed Readings That Can Have A Big Influence
A base effect is a reading that appears stronger than reality. It occurs when an irregular movement in one period skews the reading in another. For example, a mild monthly increase compared to a period that showed a decline a year before, can appear to be big acceleration for annual growth. In reality, it could have just been a delay in behaviour such as a late purchasing season.
It may not sound like a big issue, but it can cause one. The current inflation crisis is partially a result of the Bank of Canada (BoC), amongst other central banks, dismissing rising inflation in 2021, writing it off as a base effect. Consequently, they continued low-rate stimulus. The BIS attributes the global surge in home prices to this misread, since it produced excessive demand for housing.
Canadian Inflation Will Get A Boost From A Gasoline Base Effect
The pandemic resulted in a change in consumer behavior, resulting in multiple base effects. The most recent one helped to produce lower annual growth for CPI, making inflation appear under control faster than it actually is being reeled-in. Since inflation is partially a sentiment-related issue, that’s actually helping the inflationary mindset cool—along with higher interest rates.
BMO warns the rapid deceleration is about to work against sentiment soon. “We are about to find out that so-called base effects can work the other way as well on inflation,” warns Douglas Porter, chief economist at BMO.
Source: BMO Capital Markets.
Porter continues, “After providing a very helpful tailwind in knocking headline inflation down in recent months, the steady back-up in gasoline prices in recent weeks is poised to reverse some of that trend.”
Gasoline showed a contraction of 5% for annual growth at the end of July. A month prior, annual growth showed a 22% decline—which sounds like a massive acceleration. Monthly growth was just 1%, but a 9% monthly decline last July and August, respectively, is producing a base effect, explains BMO.
Canada’s Headline Inflation Will Climb—At Least Temporarily
Gasoline is always a relatively volatile component, being filtered out the central bank’s core CPI. However, headline inflation is likely to climb, potentially hitting the consumer psyche.
“So, unless we get a lot of help from other components, it looks like Canada’s headline inflation rate will push back up in the next few reports, possibly to nearly 3.5%—at least temporarily,” said Porter.
The bank doesn’t expect it to impact the central bank, forecasting headline inflation at 3.3% for the quarter. However, if the central bank isn’t careful, it might be hit with higher oil prices, and fading consumer confidence in its ability to control inflation.
“…the sustained rise in oil (and gasoline) prices to multi-month highs threatens to a) undo a good chunk of the recent moderation of headline inflation, and b) abruptly end the recent “feel-less-bad” story around inflation trends,” he said.