Why the government can’t do much about the Canada-U.S. price gap

If a recent report from the Globe and Mail is to be believed, the government’s Speech from the Throne today should discuss a variety of measures aimed at lowering the average price of goods for consumers:

The Harper government will pledge action in Wednesday’s Throne Speech aimed at eliminating the gap between the sticker price of consumer goods sold in Canada and the United States, sources say…

“Government, in consultation with consumer groups and the Retail Council of Canada, is actively monitoring the impact of these tariff reductions on retail prices paid by consumers,” Marie Prentice, a spokeswoman for Finance Minister Jim Flaherty, said.

“This is significant, as this will allow the government to assess whether tariff elimination can help narrow the price gap for consumers in Canada, and will help inform future decisions on tariff relief.”

There are many good reasons to reduce tariffs and I am eager to hear what tariff reductions and other consumer policy actions the government will propose. However, if the federal government thinks it currently has the power to reduce average consumer prices to “narrow the price gap,” it will be sorely disappointed.

A small thought experiment explains.

Suppose this slate of policies works better than expected and retail prices fall, on average, by 5%. While a significant amount, it’s still less than the estimated “retail price gap” of 15-20%. Further, this 5% price drop would then be reflected in the Canadian Consumer Price Index (CPI), which contains the “universe of goods and services […] of all consumer goods and services that can be associated with a retail price.” The CPI, like average retail prices, will also drop by approximately 5%.

However, this is the beginning, not the end, of the story. A 5% fall (or more accurately, the deflationary pressures that would cause a 5% fall) in the CPI clearly violates the mandate of the Bank of Canada:

The Bank of Canada aims to keep inflation at the 2 per cent midpoint of an inflation-control target range of 1 to 3 per cent. The inflation target is expressed as the year-over-year increase in the total consumer price index (CPI)—the most relevant measure of the cost of living for most Canadians.

In response to the deflationary pressures on the CPI, the Bank of Canada will be forced to engage in expansionary monetary policy to counteract the 5% price drop (while also ensuring the 2% year-over-year increase in prices continues as planned). This will bring average retail prices back to where they would have been had there been no policy changes.

That does not mean the policy changes were pointless. The Bank of Canada’s intervention caused by the policy changes will affect interest rates, the value of the Canadian dollar, the unemployment rate and a raft of other economic variables. The “pro consumer” policies may change relative prices (some goods will become relatively cheaper, and others more expensive), decrease (or increase) regulatory burdens, increase (or decrease) the competitiveness of border-city retailers with their U.S. counterparts and have a variety of other intended and unintended consequences.

But the one thing the policy changes cannot do is lower overall average retail prices for Canadians, thanks to the Bank of Canada’s mandate.