BoC Will Struggle to “Normalize” Policy
ECRI | Oct 5, 2017

On the heels of the strongest year-over-year (yoy) GDP growth since 2006, the Bank of Canada (BoC) hiked rates early last month for the second time in as many months. The output gap was widely invoked to explain the move; namely, even though inflation has clearly declined of late, economic growth has been above trend, which should theoretically boost inflation. However, the output gap has proven unreliable in the past.

Please recall that ECRI’s Canadian Future Inflation Gauge (CAFIG, not shown) has a lengthy real-time track record of anticipating cyclical turns in yoy Canadian CPI growth (chart). Conversely, as we showed for the U.S. in 2002 and again in 2011, the output gap is an unreliable indicator of inflation pressures, and may be misleading the BoC now, just as it misled the Fed before.

While the consensus expects Canadian inflation to move close to the BoC’s 2% target on the basis of the output gap, the latest update to the CAFIG clearly indicates whether such expectations are warranted. Without a cyclical revival in inflation – and  the recent uptick falls well short of a cyclical upturn – the BoC risks joining the world’s major central banks in their struggle to “normalize” monetary policy.