Canada's Annual Inflation and Bank's Core Rates Rose in January

The Canadian consumer price report for January showed that overall prices rose by an as expected 0.3% in the month, with the year-over-year rate rising to 1.9%, marking the fastest pace since November 2008. The Bank of Canada's core measure, which removes the eight-most volatile components, increased by 0.1%, slightly faster than the forecasts for a flat reading. The core inflation rate was 2.0% higher than a year earlier, a pickup from December's 1.5% rate.

The January inflation report showed that the index rose 0.3% on the back of higher gasoline prices (3.6%), natural gas price (7.2%) and passenger vehicles costs (+1.0%). The effect of these gains on the overall index was partially offset by falling prices for travel tours, mortgage interest costs and fresh vegetable prices. On a seasonally adjusted basis, the index rose by 0.4% largely reflecting a 1.5% jump in transportation costs.

On an annual basis, it was the swing in energy prices that made the largest contribution to the rise in the headline inflation rate. Gasoline prices were 23.9% higher than year-ago levels, a moderation from December's 25.6% rise. This was the third-consecutive month of annual increases, following the prior 12-month period when this component recorded year-over-year declines. The overall energy price component was up 8.2% compared to a year earlier. Passenger vehicle prices and insurance costs also ran faster than a year earlier as did property taxes and food purchased from restaurants. It was the first annual increase in passenger vehicle prices since June 2007. Lower mortgage interest costs, natural gas and women's clothing prices weighed on the overall inflation rate. The increase in the Bank of Canada's annual core rate was largely a reflection of higher passenger vehicle costs as well as the fact that the decline of the index in early 2009 was not repeated this year.

The rise in Canada's headline inflation rate was in large part due to movements in energy prices, with January's rise eclipsing a more modest increase recorded in January 2009. The increase in the annual inflation rate was anticipated by both market forecasts and the Bank of Canada. RBC and the Bank estimate that the headline rate will average 1.6% in the first quarter of 2010. The core measure, which eliminates the effect of the most volatile components in the CPI, has been stickier than expected averaging 1.6% in the fourth quarter and starting 2010 at a relatively high 2.0%.

Despite the higher than expected print on the core rate in January, we expect the rate of increase to slow in the months ahead, as monthly increases in the rate in February and March of last year are not matched. The deep recession of 2009 created a large output gap, and even with the economy growing at a decent 4% annual rate clip in the fourth quarter, it will take several quarters before it is eliminated. The run-up in the unemployment rate and very low capacity utilization are two indicators that slack remains in the economy. Additionally, wage growth has slowed significantly in recent months with the Bank's favoured measure showing that the annual gain in the average hourly wage rate for permanent workers rose 2.2% in January, well down from the 4.7% pace recorded a year earlier. The modest pace of wage gains and a strong currency (working to dampen prices of imported goods) point to both the headline and core rates averaging a below-target (2%) rate throughout 2010.

Domestic economic news this week are consistent with our forecast that the economy grew at a 4% annualized pace in the fourth-quarter 2009 while data for January showed solid gains in both employment and housing starts signalling that the recovery is gaining traction. The Bank will likely start to reduce the extraordinary level of accommodation being provided by low interest rates in the second half of 2010 with the overnight rate forecasted to rise to 1.25%. A further firming in the pace of economic growth and inflation rates heading toward 2% will likely see the Bank step up the pace of rate hikes in 2011, and we forecast another 225 basis points of increase.

RBC Financial Group
http://www.rbc.com

The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.