It's been a long time since the inflation rate has been the most important economic indicator in the Bank of Canada's playbook. But as the central bank vacillates over where to take interest rates after two quick hikes in the summer – and there's now little doubt that it has shifted into vacillation mode – the trajectory for rates now pivots on when, and to what degree, Canada's AWOL inflation finally stands up.
Bank of Canada Governor Stephen Poloz used a speech on Wednesday to cool the financial markets' expectations of further near-term rate hikes, which clearly had gotten ahead of themselves in the wake of the central bank's semi-surprise rate hike earlier this month. He re-emphasized – for those who somehow missed the point when the bank raised rates in July, then underlined and exclamation-marked with the September increase – that even more than usual, rate policy is dependent on the economic data right now. And it was no accident that much of a speech about data-dependence focused on one particular piece of data: inflation.
In theory, inflation is always central to the Bank of Canada's decision-making: Its formal guide for setting rates is its 2-per-cent inflation target. But after rarely rising to anywhere near that target for most of the past three years, a sustained return to the target has mostly been on the bank's back burner – placed on a distant horizon in economic outlooks, more a "we'll get there eventually" than a meaningful timeline.
The whole while, there has been a standing article of faith that once the excess capacity in Canada's economy was absorbed – the closing of the so-called output gap – inflation would finally shake off its post-Great Recession cobwebs and return to the central bank's target. And that higher interest rates would be necessary to smooth the path. Inflation would lag the closing of the output gap, but – history told economists at the Bank of Canada and elsewhere – it would happen.
Well, thanks to the acceleration of Canada's economy in the first half of the year, especially the unexpectedly strong growth surge in the second quarter, that output gap may have shrunk to near nothing – indeed, Mr. Poloz allowed in a press conference following his speech, it may even be gone completely. (Or not. We'll have to wait for the bank's next quarterly Monetary Policy Report, next month, for it to quantify its estimate of where the output gap stands.) The apparent rapid narrowing of the gap was a key reason why the central bank raised rates twice in the summer, and especially why it leaped ahead of many market expectations with the early-September increase.
But with two rate hikes in the bag, it's time for inflation to complete the equation. The bank has seen the data indicating that the output gap has substantially closed. Now it needs to see the evidence of the promised follow-on rise in inflation.
And like pretty much everything the Bank of Canada does, it's complicated. At this point in Canada's long and difficult economic recovery, full capacity has become a moving target – which makes the resulting inflationary pressure decidedly hard to pin down.
One important thing that happens when an economy's output gap closes is that businesses must add new capacity to meet new demand. When they do, that increases the economy's overall capacity and delays the closing of the output gap – thus allowing the economy to keep growing a little longer without triggering inflation. Mr. Poloz acknowledged that this is neither unusual nor unexpected. And it has certainly been going on during this year's strong economic growth phase.
But given the slump in Canadian business investment for much of the postrecession recovery, it's hard to gauge just how aggressively investments in new capacity are now bouncing back. Indeed, Mr. Poloz suggested that a considerable portion of the surge in economic activity in the second quarter could have reflected growth in supply – expansion of capacity – rather than strictly a boom in demand. Which could mean that while the output gap that the central bank was looking at a few months ago may have largely closed, new capacity may have meaningfully offset that – leaving the economy with more room to grow, and more time before inflationary pressures dictate another round of rate hikes.
At the same time, the central bank also has to keep its eye on a distinct moderating of growth in the second half of the year, as well as gauging how the economy absorbs the two rate hikes it has already booked – something complicated by the high debt loads Canadian households have accumulated after years of rock-bottom interest rates, which may make the economy more sensitive than usual to rate increases.
It all leaves the Bank of Canada highly dependent on the economic data to figure out how much excess capacity the economy still has; how quickly it is absorbing it; how much new capacity is being added; and, ultimately, where it points the all-important inflation needle.
It would be dangerous to assume that Mr. Poloz's message about this "data dependence" is an excuse to stall on further rate moves while the bank tries to figure all this out. The September rate hike was powerful evidence that just because Mr. Poloz says "we have to wait to see the data" doesn't mean the bank is on the rate-hiking sidelines. It does mean that the bank's decisions will be determined by what future economic data tell it, and when – not on some predetermined path upward that it is going to telegraph to the financial markets. If you didn't like the lack of crystal-clear signal before September's hike, you may not much enjoy the next several months, either.