Is Bank of Canada too fixated on core inflation?

With policy makers around the world scrambling to prevent another global recession, worrying about inflation is a bit like fighting the last war.

Many top central banks, particularly the U.S. Federal Reserve and the Bank of England, are putting inflation-fighting efforts on hold as they struggle to keep fragile recoveries alive. Nobody wants a repeat of what happened to the European Central Bank in the summer of 2008, when an ill-timed overreaction to wildly high energy prices made it impossible for the euro zone's economy to avoid falling into recession.

Policy makers in economies that are arguably more secure are being cautious, too.

Bank of Canada Governor Mark Carney, for instance, last week indicated he'll ignore hotter-than-expected price gains for the foreseeable future, what with bigger fish to fry like keeping the economy as insulated as humanly possible from a frightening range of external threats.

Nonetheless, the Bank of Canada's inflation-targeting mandate is up for renewal this fall, something that only comes around every five years. And though most agree the bank's current agreement with the Finance Department -- under which policy makers aim to keep prices advancing at an annual rate of about 2 per cent -- has served the country well, it never hurts to strive for improvement.

So, you can expect a lot of chatter in the coming weeks about whether, and how, the new five-year agreement should tweak the central bank's goals, or how the central bank might re-jig its own interpretation of its mandate to suit changes in the global economy that affect price trends at home.

The latest contribution to this debate comes from one of the few places in the country that studies central banking in depth, the Toronto-based C.D. Howe Institute, and its argument is intriguing.

First, some background.

Achieving price gains of roughly 2 per cent typically means Canada's central bank adjusts interest rates to ensure the annual rate of "headline'' inflation is at that target level a year or two down the road. To avoid responding too aggressively to what often turn out to be short-term swings in things like energy and food prices, it uses a "core" measure of inflation -- which excludes eight items including gasoline and produce -- as an "operational"' guide to broader, longer-lasting price trends.

During the spring and summer, this approach gave Mr. Carney the flexibility to ignore inflation hawks as they argued that domestic conditions screamed out for higher borrowing costs, regardless of the escalating signs of trouble from abroad. More specifically, although the headline rate of inflation, currently 3.1 per cent, has been above 2 per cent for several months, Mr. Carney has said for much of that time that it and the core rate will "converge'' at the target sometime next year, when temporary factors that are keeping headline inflation higher fizzle out.

But in a new paper for the institute, economists Philippe Bergevin and Colin Busby question the reliability of core inflation in signalling actual price trends -- especially in light of demographic trends and resource scarcity, both of which suggest energy and food prices, while lower than a few months ago, will be lofty for many years.

"Long-term economic trends suggest that some of the components excluded from core -- notably, those related to food and energy -- could be more subject to continuing positive price shocks,'' the authors note. ``Strong population growth, coupled with the continued industrialization of countries such as China and India, will ensure that scarce goods such as gasoline, fruits and vegetables are vulnerable to future price increases. Even if one does not place weight on these projections, the fact remains that core gives misleading signals if and when excluded components are subject to persistent shocks.''

The core rate, then, may be giving "`misleading signals'' that higher inflation now will moderate sooner than it really will. Therefore, the authors argue, the central bank should "consider de-emphasizing'' core inflation as it assesses price trends and explains its actions to the public.

Much of the paper is very tough for non-economists to grasp, even journalists like me who spend half their time decoding econo-speak, so I leave it to you to read it for yourself.

And, again, this is hardly a front-burner issue these days, given the more urgent need to make sure economies around the world continue to grow. But once the global economy is back out of the woods, questions about whether there are better ways for the central bank to measure and communicate inflation trends may get louder.

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