Does hot inflation change the outlook for rate cuts?

Portfolio managers break down potential causes of rise in core inflation, outline what the Bank of Canada may do in response

Does hot inflation change the outlook for rate cuts?

Canada’s December CPI print surprised analysts yesterday. On a year-over-year basis, the CPI rose 3.4 per cent, following a 3.1 per cent increase in November, according to a report from Statistics Canada. While inflation fell 0.3 per cent month-over-month, that’s largely due to a drop in gas prices. Perhaps most worryingly, the trim and median core rates, which filter out more volatile components of the CPI, rose by an average of 3.6 per cent, 0.3 per cent higher than economists had expected.

The CPI print poses some challenges for the Bank of Canada as it continues to fight to rein in inflation. CPI still sits outside the Bank’s 2 per cent target goal and the persistence of heightened inflation may prompt the BoC to hold off on its predicted rate cuts. According to Paul Marcogliese and Grant Connor, SVP & PM and VP & PM for fixed income at CI Global Asset Management respectively, these numbers aren’t enough to declare a delay in BoC cuts. They both believe that there is enough within the CPI numbers to show some weakness in the Canadian economy, which should lay the groundwork for a slowdown in inflation and Bank of Canada cuts roughly when predicted.

“If you look at the basics of life concept, shelter, food, and transportation, those were the only components that were actually higher on a month-over-month basis. That’s why we’re seeing the core element of CPI being a little higher than expected,” Marcogliese says. “But all the other components, they’re falling fairly aggressively. That has me wondering if the money is funnelling from discretionary spending to necessary spending in Canada, which doesn’t bode well for the strength of the Canadian economy.”

Canadians are now, in Marcogliese’s view, pulling from their discretionary expenditures to cover costs like food and a higher mortgage payment. The fact that core inflation rose while headline inflation had a less meaningful move upwards — especially when we consider an upward revision to November’s CPI — means we are seeing a shift in spending rather than an increase.

Because we are seeing a shift, rather than an increase, Marcogliese and Connor believe the Bank of Canada will probably cut interest rates in March or April as expected by most analysts. Connor notes that mortgage costs are a significant contributor to shelter inflation, and the BoC recognizes their own role in that. The bank will be aware of what’s contributing to a higher rate of core inflation and will recognize that delaying a cut may not help to alleviate those price pressures. The Bank of Canada also recently released a business and consumer survey which suggests rate hikes are having their desired impact. That should be enough for them to look past this CPI print. For the same reason, Marcogliese also expects markets to largely shrug off this news.

The release has also not changed Marcogliese and Connors’ views on the fixed income market. They are still constructive on interest rates which may be slightly less attractive than they have been, but are somewhat protected by the growing consensus around interest rate cuts this year. Volatility remains elevated but Marcogliese and Connor think that investors look through that volatility there is an attractive opportunity for investors.

After year-end predictions in 2023 forecast an easy path to slowing inflation and rate cuts in 2023, news like yesterday’s may appear to derail those predictions. However, Marcogliese and Connor believe advisors should add appropriate context for their clients and emphasize that a slight uptick in core CPI does not necessarily change broad economic outlooks.

“I would simply say that this is within the range of what you’d expect from natural volatility,” Marcogliese says. “It’s within the range of imperfect expectations. There are a lot of factors involved in an expectation but the reality is I don’t think this changes what we believe the 2024 outlook is going to be. If you do believe that inflation is coming down and you do believe that central bank overnight rates are going to come down, this is not something that I would point to and say you should change your thesis.

“You can’t ignore the fact that core was a little bit higher than expected, and I’m not suggesting that, but when you look at the details there’s a reasonable explanation as to why core was higher.”