Yesterdays decision by the Bank of Canada not to lower its discount rate as universally expected may have been a shock to economists but it also represents a watershed event of sorts in the conduct of monetary policy. It signals a welcome shift in focus from the core CPI rate to the All-items CPI rate as a guide for setting policy — and an implicit acknowledgement that asset (commodity) prices need to be considered as part of the price-stability rule.
The Bank of Canada said it did not cut because the All-items CPI would breach 3% annual growth later in 2008 as a result of soaring oil prices. The core CPI rate was still within the inflation-target range, but its good behavior did not carry as much significance with the Bank. This change in emphasis is to be applauded, I believe, because the secular uptrend in energy prices is driving a persistent wedge between the core and All-items CPI as discussed in my Dec. 20 post, Core inflation rate potentially misleading?
And its the All-items CPI that the person in the street watches. Its what can trigger an inflation psychology that leads to bargaining for higher wages the vital ingredient required for an upward spiral in inflation like in the 1970s. Besides, the core CPI would likely have been dragged higher anyway as firms increasingly passed on their rising energy costs to consumers. Take, for example, the announcement a few weeks ago of 20% price hikes by Dow Chemicals in its plastics and other product lines.