Inflation and interest rates will remain low as economy recovers

    TORONTO, Aug. 25 /CNW/ - CIBC (CM: TSX; NYSE) - The recession in Canada
and the U.S. may be over, but the damage it left behind means Canadian growth
and inflation will be muted next year, keeping Bank of Canada interest rate
hikes on the sidelines until 2011, notes a new report from CIBC World Markets.
    "While the 2009 recession may already be over, the slack it created is
both large and likely to persist," says CIBC's Chief Economist Avery Shenfeld.
"Unlike the Bank of Canada, we don't expect growth to average above the
non-inflationary potential until 2011. But even under Governor Carney's more
optimistic trajectory, inflation will still be feeling the downward pressure
of a sizeable output gap next year, one as large as we saw in the early 1980s
and 1990s downturns."
    Mr. Shenfeld finds that while the core inflation rate did not decelerate
as much as the Bank of Canada predicted earlier this year, there are reasons
to expect a further easing in core inflation ahead. "A look at the underlying
components for headline and core inflation helps identify what has, in our
view temporarily, prevented core inflation from easing much thus far. And part
of the answer lies in what economists call, the "income effect."
    He notes that by stripping out volatile items from the CPI, the Bank of
Canada's core measure now excludes most of the items that have been deflating,
much more so than in the "old" core measure that simply left out all food and
energy prices. With the "volatile" measures included, headline CPI is
negative, largely driven by the dive in gasoline prices from a year ago. Lower
gas prices have pulled down costs for intercity transportation fares as well,
which the Bank of Canada also excludes from core inflation. Other non-core
items such as natural gas, fuel oil and mortgage interest costs have also
eased off.
    "The deep dive in non-core items, has left those Canadians still working
with some spending power," adds Mr. Shenfeld. "While nominal wages have begun
to decelerate in a slack labour market, a negative year-on-year inflation rate
has meant that in real terms, the buying power of the average wage has
escalated. So after filling their gas tank and paying their new, lower,
mortgage bills, Canadians simply have more money in their pockets when they go
shopping for other items, keeping those prices aloft."
    Mr. Shenfeld notes that economic slack usually takes time in exerting its
disinflationary force. Given that wages get adjusted only as contracts come up
and that some prices are fixed ahead of time (as is the case for catalogues),
he believes the upward pressure on prices will ease in the coming months.
    "Headline inflation rates won't be as benign as they have been," says Mr.
Shenfeld. "If crude oil hugs the $60-70 range, energy will revert from a huge
negative contributor to CPI to a modest positive in early 2010, with
spillovers into related products like airline fares. But by reversing the
"income effects" noted above, that implies diminished buying power for other
goods, contributing to a cooling in core CPI. With a lag, a strong Canadian
dollar will also provide a dampening impact on retail prices for imported
goods and services.
    "All told, Governor Carney will not fret about the stickiness of core
inflation because, given time, core prices will come down. Look for headline
and core prices to cross paths in the second quarter of 2010, at a level well
under the Bank of Canada's two per cent target. As a result, Canada's
inflation rate will be no threat to the Bank easily fulfilling its pledge to
keep interest rates at a slim quarter point through mid-2010. In fact, market
expectations for rate hikes in the first half of 2010 could be a full year too
premature."
    Unlike the central bank's outlook, the CIBC report does not see the
Canadian economy gaining much benefit from a forecast U.S. recovery. It notes
that the nature of the budding recovery will be very different than what we
have seen in the past, with U.S. consumer spending taking a back seat to
government stimulus.
    CIBC's analysis finds that protectionist trade barriers and a tilt in
U.S. stimulus spending towards industries that have less-than-average
propensities to import from Canada, will dampen the benefits that this country
typically sees from economic growth south of the border.

    The complete CIBC World Markets report is available at:
    http://research.cibcwm.com/economic_public/download/saug09.pdf.

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