Core Inflation: A Closer Look and a Tentative Forecast

The “core inflation” rate’s jump to 2.5% for April 2007 (released in May 2007) was great cause for concern among many economic pundits and seemed to prompt the Bank of Canada’s announcement that it intends to raise interest rates. Of course, 2.5% must be regarded as quite moderate inflation and falls well within the Bank’s own 1%-3% range. However, this figure becomes even less significant when placed in proper context.

The annual rate for a month in this year is calculated by comparing it to the same month last year. The following is a monthly list of the “Core” Consumer Price Index (CPI):

June 2007 – ?

May 2007 – 109.9

April 2007 – 109.6

March 2007 – 109.5

. . .

June 2006 – 107.2

May 2006 – 107.5

April 2006 – 106.9

March 2006 – 107.0

Changes in the annual rate reflect not only changes in the current period, but also changes in the base period. Although prices barely increased from March to April 2007, the annual rate jumped because prices had decreased slightly from March to April 2006. In other words, a slightly higher current value was compared to a slightly lower base value.

Specifically, Core CPI was 2.3% in March (i.e. 109.5/107.0 = 1.023), 2.5% in April (i.e. 109.6/106.9 = 1.025), and 2.2% in May (109.9/107.5 = 1.022).

It’s harder to be a prophet than a historian, but looking forward, the June figures are quite likely to show a “big” annual increase in Core CPI simply because Core CPI dipped down in June 2006. Even if prices remain unchanged from May to June 2007, the annual rate will jump back up to 2.5% (i.e. 109.9/107.2 = 1.025) simply due to the reduced base.

If prices rise (as might be considered normal in a growing economy), then the annual rate will jump even higher. Of course, it is conceivable that prices will dip down enough to prevent a higher annual rate.

If the Bank of Canada announces higher interest rates on July 10, then Statistics Canada’s likely revelation of higher annual inflation on July 18 will appear to justify the rate hike. If the Bank does not raise rates, then the July 18 release will probably fuel calls for it to do so next time.

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