Deflation Watch 2009

Consumer prices fell by 0.1% between December 2008 and January 2009, reducing the annual inflation rate to 1.1%. Prince Edward Island joined the other two maritime provinces in having the dubious distinction of a negative inflation rate. This decline mainly reflected falling gasoline prices.

Lower fuel costs were partly offset by higher mortgage-interest costs due to higher real-estate prices than a year ago. But real-estate prices are now declining. Indeed, whereas total “shelter” costs increased significantly over the past year, they decreased during the past month. Falling real-estate prices will eventually join gasoline prices in putting downward pressure on annual inflation.

However, the most worrying omen of deflation was the core inflation rate, which excludes both gasoline and mortgage-interest costs. Core inflation dropped from 2.4% in December to 1.9% in January. This change reflects a more generalized decline in consumer prices. In particular, core inflation is already below the Bank of Canada’s 2% target and the 2.1% rate that it projected for the first quarter of 2009 in its last Monetary Policy Report Update.

The fact that core inflation has fallen more quickly than expected worsens the risk of deflation and lessens the risk of rising inflation. This dynamic gives the Bank of Canada even more latitude to provide economic stimulus by cutting its target interest rate on March 3.

UPDATE (Feb. 21): Quoted by The Toronto Star