Every time the monthly inflation numbers are released, central bankers seem to have an excuse for why their inflation targets are not met.  The Bank of Canada raised its overnight rate last week in defiance of declining inflation rates. The Bank’s Governor Poloz cited that inflation was held down by “temporary “ factors, i.e. a drop-in electricity costs in Ontario and lower food costs due to intense retail competition. Canada’s June CPI fell 0.1% from May; year over year the rate fell from 1.3% to 1%. This is a continuation of a decline in the core rate over the past year (Figure 1).

Figure 1

Fed Chairperson Janet Yellen also finds that the Fed cannot catch a break. June’s CPI remained unchanged from May’s rate of 1.7%; these rates are down from 2.2% in February. Moreover, the deceleration in US inflation numbers has been quite pronounced since the start of the year (Figure 2). As she often cites, Yellen added that the data on inflation can be “noisy.” She mentioned factors that seem to be temporarily depressing inflation measures, such as a pricing war among mobile phone providers and a supposed one-time drop in prescription drug prices.

Figure 2

It seems that both central bankers have taken the position that inflation will increase in the coming months. They are making sure that they do not fall behind the curve regarding their prime mandate. Yet, neither bank has provided any clue as to what will drive inflation higher. Is it a boom in commodity prices? Wage pressures? Energy prices? Or, a systematic increase in goods and services? Investors need more than blind faith to accept the need for higher short-term rates.

In fact, the longer-term bond investors, who are the ones most concerned about future inflation, have not endorsed the inflationary expectations cited by the central bankers. Figure 3 traces the decline in the 5- year breakeven inflation rate over past year. The gap between rates on nominal and inflation-protected bonds suggests that consumer prices in the United States will rise only 1.6 % a year in the next five years, down from 2 % in March. Similarly, the gap for the 10-year bonds show that investors are expecting inflation to average 1.7% over that time period.

Figure 3      5- Year Breakeven Inflation Rate

My colleague, Arthur Donner makes the case why inflation is low and will likely remain so. He states that:

Because of the hangovers from balance-sheet recessions in Japan and the U.S., fear-driven precautionary saving in China, weak consumption in productivity-constrained Europe, the demand side of most major economies remains severely impaired. Juxtaposed against a backdrop of ever-expanding global supply, the resulting imbalance is inherently deflationary.

This kind of analysis does not support the view that the decline in prices is just temporary.