Photo: MonicaArtist AI

By Michael O’Neill

Every month, hundreds of billions of dollars change hands at the push of a button. That button being the release of the monthly Consumer Price Index (CPI) by Statistics Canada or the US Bureau of Labor Statistics.

But the data is flawed.

Beneath its seemingly reliable surface lies a host of perils that challenge its effectiveness as a comprehensive measure. The index assumes that our consumption habits remain unchanged in the face of fluctuating prices. However, reality paints a different picture. When the cost of one product skyrockets, consumers often make a beeline for a more affordable alternative.

CPI often fails to account for new technology in a timely fashion and ignores geographical differences. Unpacking the subcategories and weightings of CPI exposes another crack in its foundation. While it groups items into broad categories, each with its assigned weight, this approach can distort the true impact of price changes on our wallets.

Central bankers are well aware of CPI’s shortcomings, which is why they utilize an array of other measures to track inflation and provide insight into price movements across different sectors.

The Fed scrutinizes inflation data from the Producer Price Index (PPI), the Personal Consumption Price Index (PCE), the Purchasing Managers Index (PMI), the Employment Cost Index (ECI), Average Hourly and Weekly Earnings, Nonfarm Payrolls, Import and Export Price Indexes, Consumer Confidence Index, and the GDP Deflator.

The Bank of Canada has its own favored inflation measures as well. The BoC notes on its website that “The CPI is the most relevant measure of the cost of living for most Canadians because it is made up of goods and services that Canadians typically buy.” Except it isn’t. The BoC is focused on Core-CPI and in 2017 said that its preferred Core inflation measures are CPI trim, CPI median, and CPI common. In addition, the BoC also tracks inflation readings from the Raw Materials Price Index and wage growth.

Yet, despite the reams of inflation data, both central banks could not understand why inflation was below target from 2013 until the pandemic began, and then they completely missed the post-pandemic surge.

Once the Fed and the BoC climbed aboard the inflation bandwagon, they responded aggressively, hiking rates by 525 basis points and 475 basis points respectively.

The question for markets is, “Are they done yet?”

The Federal Open Market Committee (FOMC) minutes of the July 26 meetings, the answer is “maybe yes, maybe no.”

Some participants believed the risks of hiking too high vs too little were more two-sided, implying a smaller appetite for rate increases. If there will be another increase, it won’t be in September, as the FedWatch tool odds are 88.5% for unchanged.

The Bank of Canada finds itself in a bit of a pickle.

Headline CPI rose 3.3% in July which takes it back above the BoC’s target range of 1-3% and the more important Core-CPI was unchanged at 3.2% y/y.

What to do?  What to do?

Fortunately, policymakers have a multitude of inflation measures to choose from and they will probably focus on their own CPI–trim  and CPI-median measures.  Officials will tell you that these two measures are the most accurate gauges of price trends. CPI-trim dipped to 3.6% from 3.7% while CPI median eased to 3.7% from 3.8% for a combined average of 3.65%, which is mildly better than in June. It’s easy to believe that Governor Tiff Macklem will say that inflation is moving in the right direction to justify leaving interest rates unchanged in September.

Mortgages are another dilemma for policymakers. The mortgage interest cost index (+30.6%) posted another record year-over-year gain and remained the largest contributor to headline inflation. That means another rate hike would exacerbate inflation gains, rather than ease them.

A “rates unchanged” decision won’t help the Canadian dollar.  USDCAD pushed above the last vestige of resistance (1.3500) that prevented an extended rally to 1.4000, last seen in October 2022. USDCAD has strengthened for thirteen of the past fourteen years. Will history repeat?

Slowing Chinese economic growth combined with escalating geopolitical tensions due to Russian and Chinese aggression will continue to drive safe-haven support for the US dollar. Furthermore, President Trump’s legal challenges and the resulting political implications, given his status as the leading candidate for the Republican Presidential nomination, will pose an additional risk factor.

In the quest to comprehend the complex world of inflation economics, it is makes sense not to focus on the absolute number.  It is better to try to grasp and understand the key inputs affecting the trend while recognizing CPI is a flawed calculation.

So, where does this leave the market? Should we shun CPI altogether? Not necessarily. CPI serves as a valuable reference point, providing insights into the general trends of inflation. The issue is that there are so many inflation measures to choose from, policymakers may opt for the one that best suits the message officials want to deliver.

 Pick a card.  Any card.