SPECIAL REPORT May 4, Shifting Drivers of Inflation Canada versus the U.S.

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1 Paul Ferley Assisan Chief Economis Nahan Janzen Economis SPECIAL REPORT May 4, 2010 Shifing Drivers of Inflaion Canada versus he U.S. Wih growing indicaions ha he Canadian economy is pulling ou of recession, here has been increasing aenion paid o wha his means for he inflaion oulook. A heighened scruiny of he inflaion oulook has also been promped by recen Canadian core inflaion numbers ha have been coming in sronger han expeced. Expecaions for a lower rae of inflaion were largely based on he assumpion ha significan slack buil up hrough he recession, as measured by he oupu gap (i.e., he difference beween acual level of GDP and he level of GDP associaed wih he full uilizaion of all resources), would exer coninued downward pressure on inflaion. In conras, U.S. core inflaion numbers have surprised on he downside and are currenly running a abou one half of he comparable Canadian inflaion rae. This paper looks a he significance of he oupu gap measure in deermining core inflaion in Canada and he U.S. and wheher is impac has changed over ime. The main findings of he paper are ha he oupu gap has played a less significan role in he seing of inflaion 1 in Canada since he 1990s relaive o he 1980s. Offseing his diminished effec from he oupu gap, inflaionary expecaions have been playing a greaer role. Projecing forward he inflaion oulook, his does no necessarily imply he emergence of worrying inflaion pressures as long as inflaion expecaions remain anchored close o he Bank of Canada s mid-range arge of 2%. Raher, i implies less deviaion from his rae. So alhough he oupu gap didn pu as much rend pressure on inflaion as expeced, a move ino excess demand should no ranslae ino a jump in inflaion. An analysis of he U.S. also implies ha he oupu gap has become a less significan facor over he period saring in 1990 versus he prior 10-year period. Expecaions have similarly sared o play a greaer role in how inflaion has evolved. However, one difference is ha in he U.S. he impac of he oupu gap remains of greaer significance compared o Canada. Assuming relaively similar inflaionary expecaions in he U.S. and Canada, his implies he greaer likelihood for U.S. inflaion o rend below Canadian inflaion as long as an oupu gap in he U.S. economy persiss. The laer seems likely o remain in effec over he nex couple of years given he relaively severe decline in U.S. oupu hrough he recen recession. 1 For he purposes of his paper, inflaion is calculaed using a core measure for boh Canada and he U.S. For Canada his implies he Bank of Canada core measure ha eliminaes he impac of boh eigh volaile series and indirec axes. (The impac of indirec axes is only available back 1984.) In he U.S. core inflaion is defined as excluding he impac of he food and energy componens.

2 The Canadian Model Inflaion for mos indusrialized economies can largely be viewed as a funcion of inflaionary expecaions and slack in he economy, which is ofen proxied by he oupu gap. In oher words, p = f(p exp, oupu gap) For his analysis, we esimaed a simple Phillips curve ype relaionship beween core inflaion growh, he oupu gap and inflaion expecaions for boh Canada and he U.S. We hen esimaed hese models separaely over he periods from 1980q4 o 1990q4 and 1991q1 o 2009q4. The reason for esablishing he break-poin beween samples in he firs-quarer of 1991 is because inflaionargeing was adoped as an official Bank of Canada policy mandae in February of Alhough here was no direc policy change in he U.S. in 1991, we esimaed he U.S. model over he same ime periods as he Canadian model o see how he role of he various drivers of U.S. inflaion may have changed over similar ime-periods. The 1991 break-poin also generally coincides wih he sabilizaion of inflaion expecaions in he U.S. following he run-up in prices over he firs half of he 1980s. We defined he inflaion process in Canada based on he following simple Phillips curve ype relaionship 2 : 1) π + z + ε = c + β 0 y 1 + β 1i 1 Where π is he quarer-over-quarer difference in he naural log of core inflaion muliplied by 100. c, y, and i represen a consan, he oupu gap, and a persisence erm respecively. The persisence erm is simply he lagged growh rae of he four quarer moving average of core CPI growh. A posiive relaionship beween his variable and curren inflaion growh suggess ha curren inflaion raes are correlaed wih pas inflaion raes. The oupu gap is he percen difference beween acual and poenial GDP esimaed by he Bank of Canada. The radiional Keynesian Phillips curve assumes a posiive relaionship beween he oupu gap and inflaion growh. Since our independen variable is he no-seasonally-adjused core CPI index, hisorical esimaes of seasonal facors (z) were included o conrol for normal seasonal price movemens. Ideally we would include an explici forward looking measure of inflaion expecaions, however here we are resriced by he lack of a good hisorical series of inflaion expecaions in Canada. Over he period of price argeing, we would expec ha inflaion expecaions remained sable in Canada and, hus, can be represened by a consan. Prior o inflaion-argeing, i is likely ha inflaion expecaions were largely correlaed wih pas inflaion and, as a resul, would be capured in he persisence erm. Esimaes of equaion 1 over he wo ime-periods specified are repored in Table 1 of he Appendix. They sugges ha he adopion by he Bank of Canada of an explici arge for inflaion in February 1991 had a noable impac on boh he persisence of inflaion and is response o oupu shocks. Prior o 1991, inflaion appears o have been largely a funcion of persisence (lagged inflaion growh) and he oupu gap. The posiive and saisically significan sign on he oupu gap over he 1980 o 1991 period suggess ha core CPI growh was posiively correlaed wih he oupu gap, as expeced, over ha ime-frame. The relaively large coefficien on he persisence erm (0.87) suggess ha high periods of inflaion ended o lead o furher high periods of inflaion and viceversa. 2 This model is similar o he benchmark model esimaed by Demers (2003). The Canadian Phillips Curve and Regime Shifing. Bank of Canada Working Paper

3 However, esimaing our model using only he pos-inflaion-arge era daa, core CPI growh is deermined almos enirely by a consan erm which, a.435, represens abou a 1.8% (0.435% quarerly increase compounded over 4 quarers) annual inflaion rae. The impac of he oupu gap and he persisence erm on inflaion were small and saisically insignifican over his period. This is consisen wih he hypohesis ha inflaion expecaions have been relaively well anchored a close o he Bank of Canada s 2% inflaion arge over he pas wo decades. The resul of well-anchored inflaion expecaions appears o be ha acual core CPI growh has become much less sensiive o changes in he oupu gap and much less persisen a levels below or above he arge rae. Char 1 below illusraes he change in he Phillips curve model of inflaion growh following he adopion of inflaion-argeing in Canada. The char shows projecions for he annual increase in core CPI in Canada hrough 2011 based on our simple model esimaed over he wo separae ime periods menioned above. Using he relaionship esimaed over he 1980s resuls in a much lower profile for inflaion projeced hrough 2011 han is he case using he relaionship esimaed from he period 1991 o This difference largely reflecs he greaer imporance of he oupu gap over he earlier period and he increasing imporance of expecaions over he laer period. As a resul, projecing forward using our Phillips curve esimaed over he 1991 o 2009 period resuls in a fairly seady rae of inflaion ha remains slighly below he Bank s 2% arge rae despie he slack, or widening of he oupu gap, hrough he recen recession. 2.2 Char 1: Canada Core CPI Models: Year over Year %Change Forecas Model 1980q4 1990q4 Model 1991q1 2009q Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 Sources: Saisics Canada, RBC Economics Research The U.S. Model We esimaed a similar model for U.S. core CPI growh based again on a simple linear Phillips curve model of price growh. However, for he U.S. we are able o uilize he Federal Reserve Bank of Philadelphia s Survey of Professional Forecasers inflaion expecaions measure o conrol more direcly for he impac of expecaions. As in he case of Canada, a persisence erm o capure he impac of pas inflaion on fuure inflaion is included as well as esimaes of he oupu gap derived from he Congressional Budge Office s (CBO s) esimae of U.S. poenial GDP. Esimaion resuls for he U.S. models are also repored in able 1 of he Appendix. Resuls sugges ha, as in Canada, he role of he oupu gap has diminished in he U.S. relaive o he role of inflaion expecaions since he early 1990s. This resul is consisen wih he success ha he Federal Reserve has had in keeping inflaion expecaions anchored over ha ime-period. In fac, based on he survey of professional forecasers, expecaions for 10-year average annual growh in CPI (our chosen expecaions measure) have largely remained consan a 2.5% for he las 15 years or so afer rending down from much higher levels in he mid-1980s. 3

4 However, unlike in Canada, our model does sugges ha he oupu gap coninues o have significan influence on he rae of inflaion in he U.S. This is consisen wih recen U.S. price daa and suggess ha he curren large U.S. oupu gap could explain a leas some of he curren lower inflaion growh in he U.S. compared o Canada. The below char shows projecions for he annual increase in core CPI hrough 2011 generaed using he models esimaed over he wo chosen ime periods separaely. The char shows ha he oupu gap has a much larger impac on he projecion when he model is esimaed over he period 1980q1 o 1990q4. The oupu gap sill weighs on annual core CPI growh hrough he forecas period when using projecions generaed from he model esimaed over he 1991q1 o 2009q4 ime-period, however is impac is more moderae compared o he earlier period Char 2: U.S. Core CPI Models: Year over Year %Change Forecas Model 1980q4 1990q Q1 Model 1991q1 2009q4 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 Sources: U.S. Bureau of Labor Saisics, RBC Economics Research Conclusion This paper used simple Phillips curve represenaions of he rae of inflaion for boh Canada and he U.S. o examine how he relaive roles of he oupu gap and inflaion expecaions in deermining he rae of inflaion may have changed over ime. Our analysis suggess ha he oupu gap has ceased o be a significan driver of inflaion growh in Canada since explici inflaion argeing became he official policy of he Bank of Canada. This could parly explain he relaively mued response of core CPI growh as he oupu gap widened lae in 2008 and early in 2009 and he faser-han-expeced reurn o he Bank of Canada s 2% arge. However, i also implies ha, provided expecaions remain well anchored, core inflaion could remain close o he Bank s arge rae as he oupu gap begins o close. As a resul, he Bank of Canada will likely be keeping a close eye on indicaors of Canadian inflaion expecaions 3 going forward o ensure ha hey remain anchored around he 2% arge. This would allow he Bank o wihdraw moneary simulus a a moderae rae, allowing he oupu gap o close more quickly wihou puing significan upward pressure on inflaion. Resuls for he U.S. sugges ha he oupu gap remains a significan facor in deermining he rae of inflaion, however is role has diminished since he 1980s wih expecaions increasing in relaive imporance. 3 On is webpage (hp://www.bank-banque-canada.ca/en/raes/indinf.hml) he Bank of Canada provides a lis of imporan measures of inflaion expecaions. These include he inflaion expecaions measure in he Conference Board of Canada s Business Confidence Index, monhly forecass for inflaion published by Consensus Economics, he Senior Loan Officer (SLO) survey s inflaion expecaions measure as well as expecaions implici in he spread beween nominal and real-reurn bond spreads. 4

5 Appendix Daa definiions: Table 1: Model Esimaes Canada Models U.S. Models 1980:4 1990:4 1991:4 2009:4 1980:4 1990:4 1991:1 2009:4 consan (0.10) (0.09) persisence (i) (0.07) (0.20) (0.18) (0.12) oupu gap (y) (0.02) (0.01) (0.02) (0.01) expeced inflaion (e) (0.05) (0.03) seasonal facor (z) (0.30) (0.18) (0.30) (0.12) *Sandard errors repored in brackes below coefficien esimaes Consan: A consan erm is included in he models for Canadian core CPI growh. In he absence of a separae expecaions erm he consan proxies for such in an environmen of sable expecaions. Core CPI (π): Consumer price index excluding he eigh mos volaile componens and he effec of indirec axes. Prior o 1984q2, core CPI refers o he consumer price index excluding he eigh mos volaile componens only (he series removing he impac of indirec axes was no available unil 1984q1.) Persisence(i): defined as he difference in he naural log of a four quarer moving average of he core CPI index in Canada. Oupu Gap(y): The percen difference beween acual and poenial GDP esimaed by he Bank of Canada Expeced inflaion rae (e): The annual inflaion rae expeced over he nex 10 years according o he Survey of Professional Forecasers published by he Federal Reserve Bank of Philadelphia. Seasonal Facors (z): The difference in he naural log of hisorical core CPI seasonal facors esimaed by he Bureau of Labor Saisics in he U.S. and Saisics Canada in Canada, muliplied by 100. (Saisics Canada only publishes esimaes of core CPI seasonal facors back o Prior o his, seasonal facors are deermined using he x12 seasonal adjusmen program published by he Bureau of Economic Analysis in he U.S.) The maerial conained in his repor is he propery of Royal Bank of Canada and may no be reproduced in any way, in whole or in par, wihou express auhorizaion of he copyrigh hol der in wriing. The saemens and saisics conained herein have been prepared by RBC Economics Research based on informaion from sources considered o be reliable. We make no represenaion or warrany, express or implied, as o is accuracy or compleeness. This publicaion is for he informaion of invesors and business persons and does no consiue an offer o sell or a soliciaion o buy securiies. Regisered rademark of Royal Bank of Canada. Royal Bank of Canada. 5

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