Canadian inflation is demonstrating it can be a lot stickier than the central bank expected. Last week’s CPI report showed annual growth accelerated, reversing some of the Bank of Canada (BoC) progress on taming inflation. The move sharply lowered the odds of the BoC making another cut later this month, but there’s still a chance, according to BMO. The bank notes that plenty of data will be released before the end-of-month rate announcement. While they have yet to change their expectations, they say it’s too early to dismiss the possibility it can happen.
Canadian inflation is heading in the opposite direction needed to cut interest rates. Annual growth of CPI accelerated 0.3 points to 2.9% in May, just shy of the 3% upper tolerance band. The central bank’s target rate is 2%, so heading in this direction marks an erosion in progress. Headline CPI is notoriously volatile, so the BoC will look to the more stable Core CPI measures when this happens.
Core CPI eliminates the most volatile measures, helping to provide clarity on whether the move is broad-based. Unfortunately, the BoC-preferred measure also showed abrupt acceleration for both the trim and median measures. Both averaged just 0.1% per month over the first four months of 2024, respectively. In May, they suddenly jumped to 0.3%—a rate high enough to push Core CPI out of the tolerable inflation range if it persists, even for just a short period.
“That’s not a disaster, but also provides the Bank with exactly zero additional confidence that inflation will head back to target over time,” explained Benjamin Reitzes, BMO’s Canadian Rates & Macro Strategist.
Despite the inflation jump, the bank notes the greater erosion of demand drivers hasn’t changed much. Topping his list was the wide output gap, which implies excess supply. The BoC has mentioned this issue multiple times. It’s a major precursor for downward pressure on inflation.
Erosion in the labor market makes a sudden demand surge to consume the excess supply unlikely. The bank points to the 23k jobs lost in the latest employment report, and the drop of 32k job vacancies. The BoC has repeatedly noted that inflation can return to target without the unemployment rate rising further. However, the rate climbing further confirms a loosening labor market, which provides deflationary pressure.
The next BoC rate decision falls at the end of the month. This provides plenty of time (and data) for the picture to change, with another CPI report scheduled first. In addition, BMO also notes that employment and the Business Outlook Survey land before the meeting. Those will provide further insight into whether monetary policy is too easy, restrictive, or just right.
“The surprisingly strong May inflation reading sharply lowered the odds of back-to-back Bank of Canada rate cuts, but doesn’t change the bigger picture,” warns Reitzes.
He adds, “The economy continues to have excess capacity (even with the solid April GDP) which, coupled with increasing labour market slack, points to ongoing disinflationary pressure in Canada.”
Despite seeing the potential for a cut this month, the bank has yet to change its official outlook. They reiterated their call, expecting the next rate cuts in September and December, each trimming 25 basis points from the overnight rate.
Also working against a July rate cut is the timing of the most recent one, occurring right after the measures in the latest report. The latest CPI report covers May, a month before the BoC cut the overnight rate. That cut is expected to boost consumption and thus inflation, throwing gasoline onto a fire already burning hotter than they expected. After the “transitory” fiasco, the central bank will likely embrace an overly restrictive policy instead of the risk of over-easing. The bar for another round of cuts, without a clear picture of falling demand and inflation moderation, is very high.
