While inflation gallops at an annual rate of 11.9% in Russia, is spilling into a broad basket of consumer goods and services in Japan, and its invisible hand is silently picking pockets in Europe, the United States, much of the Middle East, and Oceania, Canada continues to enjoy declining inflation.

The Toronto Star reported:

Canada's inflation rate continued its downward slide in January, dropping 0.2 percentage point to 2.2 per cent and giving the Bank of Canada more room to cut interest rates next month.

Statistics Canada said Tuesday the year-over-year rise in the consumer price index was the smallest since August, largely as a result of the stronger Canadian dollar and the one-percentage-point drop in the federal goods and services tax on Jan. 1.

Canada's core inflation rate (the inflation measure in which food and energy prices are excluded) fell to 1.4%. That was the lowest figure since July 2005. Low inflation gives the Bank of Canada room to reduce interest rates to stimulate the economy, should such steps be necessary, with reduced risk of igniting inflationary pressures.

Bank of Canada will maintain a focus on inflation. Reuters reported, "The Bank of Canada said on Tuesday its focus, heading into next week's monetary policy announcement, remains on keeping inflation under control, despite concern the robust Canadian dollar is hurting sectors of the economy."

Canada also enjoys a strong currency. In part, Canada's relatively higher interest rates have helped the Canadian dollar gain strength, in which it reached parity with the U.S. dollar last year and now frequently trades somewhat more strongly than the U.S. dollar. In part, Canada's fiscal discipline in which that country is forecast to continue running budget surpluses, albeit smaller ones, in the face of a softening economy, has given investors confidence in the Loonie. A stronger currency is disinflationary, as it makes imports relatively less expensive.

What's more, Canada appears to be taking a page out of the supply side book, in combining tax cuts (a reduction in the Goods and Services Tax) with relatively tight money. Under supply side theory, which should not be confused with being synonymous with the Laffer Curve (a concept that Supply Siders embrace that suggests that at certain tax rates, tax cuts can foster greater tax revenue), the supply curve is pushed to the right and that leads to producers making available a higher quantity of goods for a given price (a disinflationary impact). At the same time, relatively higher interest rates suppress the demand curve to the left, and that also has a disinflationary impact.

Finally, The Star reported, "Mortgage interest costs rose 7.6 per cent from a year ago, while home prices rose 4.5 per cent." Higher mortgage costs discourage speculative activity in the real estate industry. Hence, unlike the U.S. in which a real estate bubble swelled and then began to contract, sending home prices 8.9% lower according to the Case-Shiller Index and gross private domestic investment in residential structures 18.6% lower, Canada enjoyed a rise in home prices of 4.5%.

The importance of erecting barriers to bubbles cannot be understated and is particularly relevant to the current economic challenges confronting the United States. Former Treasury Secretary Robert Rubin explained in his memoirs In An Uncertain World (Random House, 2003):

The tendency to go to financial excess seems to stem from something inherent in human nature, as does the remarkable failure to draw lessons from past experience. The collapse of the southwest real estate bubble in the United States didn’t prevent investors from overinvesting in Asia. The Asian crisis didn’t prevent the NASDAQ bubble from developing. The proclivity to go to excess is a phenomenon of collective psychology that seems to repeat itself again and again."

Beyond 2003, the U.S. witnessed the rise of the present real estate bubble that is now unwinding. Although U.S. policymakers do not have the benefit of having taken Canada's proactive steps e.g., in the form of increased mortgage rates, they can and should resist the hazardous temptation of bailing out the housing market. The policy emphasis should be on preventing the spread of the housing contagion while leaving the bubble to fully deflate. Contrary to the arguments of would-be interventionists, the unwinding of the bubble is actually a good thing. It is cleansing excessive risk from the marketplace by bringing real estate valuations, not to mention asset-backed financial instruments, back into line with historic norms. If policymakers can concern themselves with the focus on this beneficial aspect and strictly confine themselves with the long-term viability of the U.S. economy, seek only to limit the spread of the fallout from the housing sector while allowing the bubble to continue to deflate, they can avoid the moral hazard that would only hasten the development of a new bubble, in what has been a bubble-prone sector of the economy.

To further illustrate Secretary Rubin's point about a seeming inability for society to learn from its past experience, one can reference the economic situation in 1854. At the time of a real estate bubble that had begun to contract, much as is happening today, The New York Daily Times opined, "No special blame rests with the property holder—none perhaps with the speculator and builder, often one and the same party, on ground lease; but the mischief has been done and must now be undone and at their cost." That was sound advice then. It is just as sound today. But whether policymakers learn from past experience remains to be seen.

In the end, going back to Canada's success story, there are some crucial lessons that can be learned from the Canadian experience. These lessons include:

• Sound monetary policy can keep inflation relatively low even when inflation is becoming increasingly prevalent in a growing share of the world's economies.

• Fiscal policy matters. Sound fiscal policy can help keep a nation's currency strong. Fiscal discipline can also provide flexibility for supply side measures.

• A strong currency is in a nation's interest. It can help promote price stability with its disinflationary impact. It can also provide an important incentive for domestic producers to push the frontiers of productivity necessary to become world-class competitors.

• Barriers to bubbles in the form of relatively higher interest rates can reduce the risk of their appearance, as well as the subsequent fallout from their collapse.

Originally Posted by donsutherland1 • Sound monetary policy can keep inflation relatively low even when inflation is becoming increasingly prevalent in a growing share of the world's economies.