Inflation's return could shock a generation that's never seen it: Don Pittis

Friday's headline cost-of-living numbers showed pricesare on the way down. Theymay have been deceptive.

Beneath theheadline figures lurk signs inflation is brewing in Canada, part of a trend that isemergingaround the world.

For a generation that has never experienced serious inflation, a trend toward steadily rising prices may mean a younger generation doesn't realize it could happen.

Inflation's big surprise

"We're moving into difficult territory. Inflation could be the big surprise of this year," UBSchairAxel Weber,former chief ofthe German central bank,told the London Telegraph at last week's World Economic Forum in Davos, Switzerland.

While economists fear deflation, from the point of view of financial markets, newsigns of inflation are worrying because they push interest rates higher, cutting the value of existing bonds.

Canadian borrowers know bond traders aren't the only onesto be affected by rising rates. But it's fair to ask why anyone would be worried about inflation in Canada when the official inflation rate has declinedfrom an annualized 2.1per cent to 1.9per cent.

• Inflation rate cools to 1.9% in December on cheaper gas, phone plans

And the simple answer is that for people watching the inflation trend,the important number is core inflation. And core is rising.

"Two of the three [core] measures rose, with the trimmed mean up a tick to 1.9 per cent, the weighted median holding fast at 1.9 per cent, and the common component edging up a tick to 1.6 per cent," Doug Porter, the Bank of Montreal's chief economist, said in his Friday analysis of the Statistics Canada data.

A rising trend

The Bank of Canada and other central banks around the world use core, not headlineconsumer price index (CPI) to decide whether inflation is on the way up and whether they must begin to raise rates to combat it.

• U.S. core inflation jumps, boosting likelihood of rate hike

While Canadians saddled by rising debt payments may disagree,many economists will tell you thatinflation is not a bad thing.

"I think right now, we're finally where we want to be with our levels of inflation," saidLuba Petersen, a research economist who doesexperiments on the behaviour of people exposed torising prices under laboratory conditions.

Anything below three or four per cent inflation can remain stable and actually be healthy for an economy,said Petersen an assistant professor at Simon Fraser University. But a sudden change in inflation could affect people who have never experienced it before.

"We've had a generation of young people who have seen hardly any inflation and therehas been some experimentalwork . . . showing that youngpeopleoverreact to their recent experiences," Petersen said."If, for example, wewere to get a big spike in inflation, we might expect that young peoplewould overreact."

Eager to raise rates

She said that could have the effect of propelling inflation even higher.

But Petersen is convinced that the world's central bankers would be quick to jump on any real signs of rising prices.

"If inflation did start rising, central banks would be eager to raise rates," she said.

Economist David Laidler is not so sure. In his nearly 80 years, the professor emeritus at Ontario's Western University has seen repeated bouts of serious inflation.

In 1955, U.S. central banker William McCheneyMartin made a famous admonition on the importance of raising rates early to keep inflation under control. But since then,Laidlerhas lived through repeated bouts of sharply rising prices. Somehow, central banks just couldn't seem to bring themselves to raise rates soon enough.

"I'm old enough to have seen that happen," says Laidler, whoexperienced a bout of 25 per cent inflation in the 1960sin the U.K. that got him into financial trouble. He also lived through two sharp spikes in the 1970s and 1980s where inflation kicked up into the teens.

From his own experience, he describedhow people who have never seen inflation would experience it

"They would see price labels in the supermarketthat seem to have been there forever suddenly creeping up," he says. "They would see gas suddenly not quite going back down afterit's gone up. After a little while, they would see the interest rate on their mortgage goingup and they'd be kicking themselves because they hadn't taken the fixed rate, which seemed so incredibly high."

At the beginning, he said, wages rise too. That makes people feel rich and spend more than they otherwise would.

But how could it happen? Some economists believe that the effects of cheap money and high public debt really have been stimulating the economy, creating pent-up inflation that will eventually show itself. Others say the rise in house prices has not been correctly counted in inflation and will only show itself as interest rates rise.

"One of the things that really drove inflation in the 60s and the 70s was that theU.S. gave up on reasonable economic policy," Laidler said.

With huge government deficits from the Vietnam war, the central bank was directed to let the government keep spending by buying up bonds, he said.

"There was a kind of looking the other way in American politics that let inflation get out of hand."

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