The headline inflation rate -- the year-over-year change in the Consumer Price Index -- increased to 3.3 percent in March. This increase was largely due to higher prices for energy and food; gasoline prices alone were up 18.9 per cent over March, 2010.

An inflation rate of 3.3 per cent is well over the Bank of Canada’s target of 2 per cent: does the March CPI release put that target in danger? Will higher and more volatile fluctuations in energy and food prices drag us back to the days of high and unstable rates of inflation?

The answers to these questions are no and no. The only way higher energy and food prices will generate higher inflation is if the Bank of Canada lets them. And the Bank has repeatedly demonstrated its ability and determination to keep inflation rates at an average of 2 per cent.

Firstly, the numbers we’re seeing now have been seen before. Since the adoption of inflation targeting, headline inflation numbers have drifted above 3 per cent four times before this current episode. Moreover, the gap between the headline and ‘core’ rates of inflation -- I’ll be getting back to core CPI shortly -- is high, but it is not at levels we haven’t seen before; see the accompanying graphs. The Bank has managed to bring inflation back down to target before, and there’s little reason to doubt that it will be able to do so again.

Secondly, it’s important to remember that inflation is a sustained increase in all prices; ‘pure’ inflation occurs if all prices increase in the same proportion, leaving relative prices unchanged. Relative price changes are not signs of inflation: saying that the price of apples relative to the price of oranges has increased is the same thing as saying that the relative price of oranges has decreased.

The increase in the headline March CPI inflation rate is due to increases in a relatively small number of goods, and is best seen as a change in relative prices that will have only a transitory increase in the CPI. There are two ways that headline CPI can return to target. The first is that consumers adjust their spending patterns and substitute away from the goods whose prices have risen; the resulting fall in demand will bring prices back down. If this doesn’t happen, prices of other goods can fall -- or at least rise more slowly -- so that the rate of inflation of the broader index falls back to target.

The Bank of Canada is preoccupied with inflation, not fluctuations in relative prices, so the current increase in the CPI will only be a problem if firms and workers start using 3 per cent as a benchmark for increases in wages and the prices of other goods.

Even though the target is the headline CPI inflation rate, it is the Bank’s opinion that the core CPI inflation rate is a better predictor for future inflation. The components of core CPI are generally those whose prices are set infrequently and whose increases reflect expectations for future inflation as well as market conditions. If expected inflation starts to rise, it will be more visible in the core rate than in the headline number.

Core inflation is currently within the Bank’s comfort zone, but if it starts to drift up, the Bank can -- and will -- increase interest rates in order to reduce inflation, just as it has in similar episodes over the past twenty years.

Article provided via the Globe and Mail

http://www.theglobeandmail.com/report-on-business/economy/economy-lab/stephen-gordon/carney-wont-panic-over-inflation-spike/article1994082/