Canada: Core Inflation Likely to Back Track

• The Bank of Canada's core measure of inflation rose to 2.0%. However, the rise in core inflation was largely due to a base year Effect, and there are reasons to believe that core inflation will continue to moderate in the near-term.

Canadian headline CPI rose 1.9% in January, up from 1.3% in December, the largest increase since November of 2008. Energy prices continued to exert significant upward pressure on prices for a fourth consecutive month, however, unlike past months, energy costs were not the only source of inflationary pressures in December. the Bank of Canada's core measure of inflation rose to 2.0%.

While it might seem surprising that just two quarters into the recovery, and with an estimated output gap of 3.5%, the Bank of Canada's measure of core inflation has reached its 2% target, almost a year and a half in advance of its estimate. However, the rise in core inflation was largely due to a base year effect – prices fell significantly in January of 2009. This effect will fall out of the equation in February, and there are reasons to believe that core inflation will continue to moderate in the near-term.

Outside of energy, Canadian consumers experienced a sharp (but not broad based) increase in durable goods and services excluding shelter. The sharp jump in durable good prices was largely driven by a 3.2% increase in costs of leasing and purchasing a motor vehicle, the first increase in over three years. Looking back, a year ago January, autodealers were offering deep discounting to attract buyers and draw-down high inventory levels. With the economy improving, consumer spending on the rebound, and motor vehicle inventory levels back to historical norms, its not surprising that auto dealers will start to rein in purchase incentive programs. Over the last four months, auto leasing and purchasing prices have already risen to pre- recession levels, and a soft economic recovery may limit future monthly price increases.

Meanwhile, a 4.4% rise in communication costs (internet, telephone, and postal services), an 8.3% increase in other household service prices, and a 7.7% increase in motor vehicle insurance premiums were the main contributor to the increase in service costs. While prices for these services tend to be less cyclical than others, the sharp jump in these prices in the early stages of the recovery is rather surprising, since history shows that the rise in service prices traditionally slow in the later stages of economic recessions and the early stages of recoveries.

Beyond these goods and services, there was a more broad based moderation in other prices (such as shelter, food, household furnishings and equipment, clothing and footwear, and last but not least alcoholic beverages) that is expected to continue in the coming months. First, the accumulation of significant slack in the Canadian economy during the economic downturn will continue to exert downward pressure on prices for many goods and services. A slow economic recovery suggests that the slack will only be fully absorbed by the end of 2012. Second, food price inflation continued to moderate for an 11th straight month. This moderation in food inflation is expected to continue until mid-2010, as input costs for food products have come down significantly over the last 5 months, and generally take close to 12 months to impact the price of food products at stores. Third, the Canadian dollar has appreciated significantly over the last four months and historical experience suggests that it takes up to 6 months for a currency appreciation/depreciation to pass through to the price of consumer goods, so the exchange rate could have a dampening impact on inflation until mid-2011. As such, we believe that the recent jump in core inflation should not be a cause for concern for the Bank of Canada as of yet, and we believe that core inflation will moderate to the range of 1.6-1.8% over the year.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.