Falling loonie staves off deflation threat as core inflation holds steady

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Slumping oil continues to take a deep bite out of Canadian consumer prices, but the latest inflation report suggests the fall of the Canadian dollar is cushioning the blow and keeping deflation worries at bay.

Statistics Canada reported Thursday that its consumer price index rose 1 per cent from a year earlier in January, the slowest pace since November, 2013, and down sharply from 1.5 per cent in December. On a month-to-month basis, the CPI fell 0.2 per cent in January from December.

The decline was again led by a sharp drop in gasoline prices, which fell 12.4 per cent month over month and 26.9 per cent year over year.

However, the core inflation rate, which excludes the eight most volatile components of total CPI, including gasoline and other fuels, held steady at 2.2 per cent, evidence that the energy price slump still isn't having a deep impact on the country's broader inflation picture. Economists suggested the fall of the Canadian dollar, in response to oil's plunge, may be feeding broader inflation and mitigating the impact of tumbling fuel prices by raising the cost of imported goods.

"Aside from gasoline, there were few signs of weakness in Canadian price trends last month. In fact, the lower loonie's wingprints were all over this report," Bank of Montreal chief economist Douglas Porter said in a research note.

After peaking at 2.4 per cent in October, Canada's inflation rate has been in rapid retreat, driven by the sharp decline in the price of oil. But the core inflation rate, considered a better indicator of broader inflationary pressures in the overall economy, has remained relatively steady and slightly above the Bank of Canada's 2-per-cent inflation target, the central bank's key determinant for interest rate policy.

Several sectors with heavy import components are showing significant upturns in their inflation, evidence of the impact of the weaker Canadian currency. The big contributor was food, with prices up 4.6 per cent year over year and 1.2 per cent in January alone.

That increase was due mainly to big spikes in the prices of fresh fruit (up 6.6 per cent month over month) and fresh vegetables (up 5.2 per cent), both of which are almost entirely dependent on imports in the winter months. The cost of motor vehicles rose 0.6 per cent in the month, their fourth straight month-to-month increase.

Mr. Porter noted that clothing and footwear prices, "after declining almost consistently over the past decade" thanks to a strong dollar and cheap overseas manufacturing, were up 2.1 per cent year over year.

Over all, seven of the eight major segments within CPI posted year-over-year gains in January. The only segment down from a year earlier is transportation (which includes gasoline), off 5.3 per cent.

On a month-over-month basis, unadjusted for seasonality, five of the eight segments showed gains, led by the jump in food prices. The only declines were in transportation, down 2 per cent; and recreation, education and reading, off 0.5 per cent. Prices for all energy components of the index fell 6.2 per cent in the month.

Excluding food and energy – two big and volatile components heading in opposite directions – CPI was up 0.2 per cent month over month and 1.9 per cent year over year.

Despite the continued slide of overall inflation, the January numbers were stronger than economists had expected, strengthening the market's new expectation that the Bank of Canada will hold steady on its key interest rate at its monetary policy decision next Wednesday.

When the week began, financial markets were pricing in about a 75-per-cent likelihood the central bank would follow up its surprise January rate cut, of one-quarter of a percentage-point, with a similar decrease next week.

But following a speech Tuesday from Bank of Canada Governor Stephen Poloz, who hinted strongly at a wait-and-see stance for the March rate decision, the markets are now pricing in only a 20-per-cent chance the central bank will cut again on Wednesday. January's stable core inflation helped solidify that view.

"The steady performance in the core measure should allay concerns at the Bank of Canada about inflation expectations becoming unmoored," Dawn Desjardins, assistant chief economist at Royal Bank of Canada, said in a research note.

And Canadian Imperial Bank of Commerce economist Nick Exarhos said the weaker currency should continue to prop up the core inflation number over the next several months.

"Our analysis suggests that pass-through from the currency gradually feeds through to readings on core, with the year-on-year impact peaking 12 months after the shock," he said in a research report. "We don't expect the [core] trend to soften materially from here."

Canada's Consumer Price Index