Observation TD Economics www.td.com/economics November 24, 2010 HIGHLIGHTS THE CANADIAN DOLLAR AND INFLATION - TALE • Canadian core inflation accel- OF A BUMPY RELATIONSHIP erated more than expected in October, to 1.8% y /y%, up from Yesterday’s inflation report raised some eyebrows by showing that Canadian 1.5% in the previous month. More core inflation accelerated more than expected in October, reaching 1.8% year- than half the acceleration can be over-year, up from a more moderate 1.5% in the previous month. As noted in TD explained by a 0.5% gain in the Economics commentary, the acceleration in core inflation was at odds with the price of goods, excluding food current economic backdrop – in particular, the large amount of economic slack and energy. that persists and a strong Canadian dollar. Even more surprising was that more • We have estimated that on aver- than half the acceleration in core inflation can be explained by a 0.5% annual gain age a 1% appreciation/deprecia- in the price of goods, excluding food and energy. Given that this component is tion in the Canadian dollar leads the most sensitive to both the slack in the economy and the Canadian dollar, the to a 0.4% decrease/increase in the upturn in October is very surprising. price of these goods with a six-to- nine month lag. Last week, the Bank of Canada’s Review published research that indicated that the pass-through of the Canadian dollar to the price of imported goods was • However, the recession stripped retailers of their pricing powers, minute, and has been and as a result, they could not declining over time. CANADIAN CONSUMER PRICE INFLATION (y/y% change) pass the sharp depreciation of the On the surface, Oc- Canadian dollar, which increased tober’s inflation re- Goods excl. food and energy BoC Core Inflation 1.0 3.0 import costs during 2008/2009 port seems to support 0.5 onto consumer prices. As a re- the Bank of Canada’s 2.5 0.0 sult, while the Canadian dollar findings – as that -0.5 remains 1.0% below its 2008 peak, month’s rise in goods 2.0 -1.0 the cost of goods excluding food inflation came despite -1.5 1.5 and energy remain 0.5% below a 3.5% appreciation -2.0 the price level at that time. As 1.0 such, we believe that the sharp in the Canadian dol- -2.5 acceleration in this component of lar against the U.S. -3.0 0.5 the CPI is a reflection of retailer dollar from year-ago -3.5 prices picking up as demand has levels, and one would -4.0 0.0 2007 2008 2009 2010 improved over the last year of expect competition to economic recovery. lead importers to pass Source: Statistics Canada, Haver Analytics • Going forward, the cost of goods, along savings to con- excluding food and energy, are ex- sumers. Normally, an appreciation in the Canadian dollar leads to lower inflation pected to take their cue from the because a rising loonie makes imported goods cheaper on the international market. slack in the Canadian economy This begs the question of whether the Canadian dollar matters for the inflation in the near-term, rather than from outlook? This matters because, if driven by strong economic fundamentals, an Canadian dollar movements, giv- appreciating Canadian dollar can help offset inflationary pressures brewing on ing the Bank of Canada the flex- the domestic front, allowing the Bank of Canada to keep interest rates low admist ibility to keep rates on hold. global economic uncertainty. But, if this type of upside surprise on inflation were to continue, the Bank of Canada could be pushed off the sidelines sooner than Diana Petramala, expected. Here, we present the case why we think that the pass-through might be Economist (Canada) more significant than the Bank of Canada research may suggest, and the upside 416-982-6420 surprises in inflation going forward are unlikely to continue. mailto:firstname.lastname@example.org In doing so, we look at the relationship between goods, excluding food and energy, and the Canadian dollar. Examples of these goods are furniture, electronic equipment, clothing and footwear, and automobiles. Many of these goods are Observation TD Economics 2 November 24, 2010 www.td.com/economics CANADIAN CPI: GOODS EXCLUDING FOOD AND nadian dollar. By the same token, as the economy begins ENERGY VS. THE CANADIAN DOLLAR to improve and the Canadian dollar strengthens, they also (y/y% change, normalized) do not pass-through the Canadian dollar appreciations in 4 the form of lower consumer prices as retailers make up for 3 excess lost revenue. capacity This is consistent with the experience over the last two 2 avrg. C$ 2 yr. change years. When the recession hit, retailers did not pass the 1 =0.4% full extent of the sharp Canadian dollar depreciation onto 0 consumer prices. Annual inflation in goods went from a -1 record low -3.42% in October 2008 to -0.31% in August 2009 (6-months after the Canadian dollar low) – but this -2 C$ lagged 6-months was not as large a swing as could have happened if retail- Goods CPI ex. food and energy -3 ers had been willing or able to pass through the full extent 1990 1991 1993 1995 1997 1998 2000 2002 2004 2005 2007 2009 of the Canadian dollar depreciation onto consumer prices. Source: Statistics Canada/Haver Analytics Since the low reached in April of 2009, the Canadian dollar has appreciated 20%, but the price of these goods has been imported for consumption. As such, as economists, we call accelerating through this year. Looking beyond the volatile these goods tradable goods. If there were any pass-through movements over the last two years tells a different story. of the Canadian dollar onto consumer prices, it would be At its current level of 98 U.S. cents, the Canadian dollar is most evident in this component of the consumer basket. We 1.0% below its peak level in 2008 – which should act as an find that in general, there is a tight relationship between the inflationary pressure on good prices. However, the price of price of goods excluding food and energy and the Canadian goods, excluding food and energy, is 0.5% below its value dollar. In fact, we have estimated that on average a 1% at the time the loonie peaked in 2008. The result being that appreciation/depreciation in the Canadian dollar leads to a retailers did not, or rather could not, pass along the depre- 0.4% decrease/increase in the price of these goods with a ciation of the Canadian dollar onto consumers in the form six-to-nine month lag. However, this relationship can vary, of higher prices during the depths of the recession. The ac- depending on the amount of economic slack in the economy. celeration in goods inflation in October likely reflected the For example, prices of goods that are heavily imported fact that the price of goods are now playing catch-up to the moved very closely with the Canadian dollar over the time Canadian dollar, as demand has improved over the last year. periods of October 1999 to June 2002, and May 2006 to The changing dynamics have been most evident in the December 2008 – periods when the Canadian economy was Canadian auto sector, which also happens to be the sector operating above or close to full-capacity. Meanwhile, the contributing the most to goods inflation. During the depths relationship is less clear in times of heavy economic slack, of the recession, the auto sector implemented deep discount- such the most recent recession. On a short-term basis, movements in the price of tradable goods and the Canadian GOODS EXCLUDING FOOD AND ENERGY VS. THE dollar may deviate, particularly during weak economic CANADIAN DOLLAR times. Over time, however, the cost of tradable goods will 1.4 (level indexed at Jan. 2008=1) ultimately be determined by the level of the Canadian dol- Canadian dollar 1.3 lar and eventually the price of tradable goods will adjust to Depreciation reflect movements in the Canadian dollar. 1.2 Goods, exc. food and energy CPI While anecdotal, we can think of a simple rationale 1.1 for the changing relationship. During times of economic weakness in the past, interest rates were lowered, and the 1.0 Canadian dollar weakened. Given the accumulation of slack in the economy, retailers are stripped of their pricing power 0.9 during economic downturns and are unable to pass-through 0.8 dollar depreciations onto consumer prices. As a result, dur- Jan-2008 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Jul-2010 ing economic downturns, the price level of tradable goods Source: Statistics Canada/Haver Analytics is likely below what it should be given the level of the Ca- Observation TD Economics 3 November 24, 2010 www.td.com/economics hold steady in a range of 98 U.S. cents through the first half COST TO PURCHASE AND LEASE AUTOMOTIVES of 2011 as concerns over the U.S. economic outlook weigh 0.4 Contribution to goods inflation, % Price level 105 on the Canadian currency. More importantly, we expect the cost of goods, excluding food and energy, to take their cue 0.2 100 from the slack in the Canadian economy. After delivering 0.0 95 a V-shaped recovery in the early stages of the economic re- covery, Canadian economic growth moderated to a 1-2.0% -0.2 90 pace in the second half of this year – and economic slack -0.4 85 is expected to be eaten-up at a much slower pace than was experienced over the first year of the economic recovery. -0.6 80 In this environment, retailers may find it difficult to regain -0.8 75 pricing power. May- Nov- May- Nov- May- Nov- May- As such, the month’s acceleration in goods, excluding 2007 2007 2008 2008 2009 2009 2010 food and energy, and overall inflation is likely to prove short- Source: Statistics Canada/Haver Analytics lived. We remain of the view that the Bank of Canada’s core measure of inflation will continue to moderate through the ing programs to attract buyers and clear high inventory levels first quarter of 2011 – reaching a trough of 1.5-1.6% - and – despite the upward cost pressures faced by this sector as then only gradually returning to 2.0% by mid-2012. This the Canadian dollar depreciated sharply. Now, as auto sales is consistent with our view that the Bank of Canada will have improved significantly over the last year, auto retailers remain on hold until July of next year. have started to remove some of the discounts offered during 2009, leading to sharp gains in the purchase and leasing of BANK OF CANADA CORE INFLATION automobiles component of the consumer price index. While (year-over-year % change) the annual price inflation of motor vehicles has risen sig- 3.0 nificantly over 2010, the consumer price of purchasing, or Forecast 2.5 leasing, an automobile remains well below 2008 levels. Conclusion 2.0 The bottom line is that the Canadian dollar matters 1.5 significantly for the inflation outlook, particularly over the 1.0 medium-term. And, should inflation pressures brew on the domestic front, a strong Canadian dollar could act as buffer 0.5 giving the Bank of Canada some breathing room with mon- etary policy For now, however, the Canadian dollar does 0.0 2004 2005 2006 2007 2008 2009 2010 2011 2012 not pose a risk to our inflation outlook. While we have seen some strength in the Canadian dollar recently, we simply Source: Statistics Canada/Haver Analytics, Forecast by TD Economics as of October 2010 don’t see much further appreciation in the Canadian dollar in the near-term. It is our view that the Canadian dollar will This report is provided by TD Economics for customers of TD Bank Financial Group. It is for information purposes only and may not be appropriate for other purposes. 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