While the Bank of Canada is closely monitoring inflation to gauge when it can start lowering interest rates, National Bank says the central bank’s methodology is flawed.
“In our opinion, official data understate the progress made by the Bank of Canada in curbing inflation, which poses a risk that the central bank is calibrating its monetary policy too restrictively,” wrote National Bank Financial economists Matthieu Arseneau and Alexandra Ducharme.
In their assessment, they say the the Bank of Canada’s preferred measures of core inflation—CPI-trim and CPI-median—which are supposed to strip out the most volatile price categories, are still being “contaminated” by the sharp rise in interest costs and rents.
In a March 6 speech, Bank of Canada Governor Tiff Macklem explained how price pressures remain even when removing the most volatile mortgage interest cost and rent increases.
“If you look beyond shelter, we are seeing that underlying inflationary pressures persist. And one way to look at that is, if you look at our preferred measures of core (CPI-trim,
CPI-median), those exclude the things that are going up the most and the things that are going down the most. Most of the shelter components are in the things that are going up the most, so they’re excluded from those core measures. Those core measures are still running over 3%.”
However, the NBF economists say they “respectfully disagree” with the Governor.
“Given their imposing weight (11% of the total basket), [rents and mortgage interest costs] act as magnets for the core measures of inflation,” they wrote. “In other words, they occupy the space of the components at the top of the distribution range, and thus indirectly contribute to the rise in inflation calculated by these measures.”
Making the case for CPI-X
Headline inflation came in at 2.9% in March, with mortgage interest costs up (+25.4% year-over-year) once again being the largest contributor. Although that’s down from the 26.3% rate in February, NBF says that if mortgage interest costs weren’t included in the BoC’s CPI calculations, overall inflation in February would have been reduced to just 1.9%, below the central bank’s inflation target.
How CPI-X differs from today’s method
CPI-X differs from the current methods of calculating core inflation—CPI-trim and CPI-median—in the specific method it uses to measure inflation by excluding certain elements. While CPI-trim and CPI-median also aim to provide a clearer view of underlying inflation trends by removing extreme values, they do so differently:
- CPI-trim removes a fixed percentage of the highest and lowest price changes from the calculation.
- CPI-median calculates the median price change observed, representing the middle price change and ignoring all others.
CPI-X, on the other hand, would typically exclude specific items or sectors known to have volatile price movements, predetermined by the methodology. This makes CPI-X more tailored to exclude certain known distortions in price data.
Already a precedent for excluding mortgage interest costs
For those who argue against excluding this component, the economists point to the central bank of Sweden, which, since 2017, has excluded the impact of mortgage interest costs “so that the conduct of monetary policy does not directly affect the measure of
targeted inflation.”
The Bank of Canada itself used CPIX3 as its preferred core inflation measure prior to 2016. This explicitly excluded mortgage interest costs as well as seven other volatile categories.
“The Bank of England, the European Central Bank and the Federal Reserve do not share this problem, as the inflation measure they target does not include the mortgage interest component,” they note.
“In our opinion, CPIX is the more appropriate measure to navigate the current inflationary episode and should be reinstated as a key measure of core inflation,” they argue. “This indicator now shows that underlying inflation is back on target.”
