August CPI a welcome win in Bank of Canada's inflation fight

Canada's inflation story diverges from the U.S. with second-straight month of decline, says economist

August CPI a welcome win in Bank of Canada's inflation fight

After months of being panned for being “behind the curve” on inflation, policymakers at the Bank of Canada enjoyed a measure of redemption yesterday as Statistics Canada unveiled the official inflation figures for August.

“Canadian inflation printed lower in August compared to economists’ expectations, and that really differs from the recent U.S. inflation report,” said Todd Mattina, chief economist at Mackenzie Investments. Last week, the U.S. Bureau of Labor Statistics revealed headline inflation reached 8.6% in August, higher than the market forecast of 8.3%.

In Canada, the latest annual CPI print came in at 7%, extending a slowdown from 8.1% in June and 7.6% in July, and reflecting a much more pronounced deceleration compared to the 7.3% expected in consensus forecasts. Core inflation also showed signs of cooling as the average of the three core indicators tracked by the Bank of Canada dipped to 5.2% in August, in contrast to roughly 5.4% the month prior.

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Bond markets responded favourably to the good-news surprise, Mattina noted, with yields moving lower across the Canadian yield curve even as U.S. Treasury yields moved higher. The Canadian dollar, meanwhile, lost roughly half a percent in the hours after the report and dipped just below 75 cents, the lowest since 2020.

Drilling into the CPI data shows Canadian shelter costs declined month-on-month, in line with the softening in the housing markets over the summer. That’s a crucial development, Mattina stressed, as shelter makes up 30% of Canada’s CPI basket and tends to be a sticky sub-element of the price index.

“It really differentiates Canada from the U.S.,” Mattina said. “In the U.S., we saw shelter costs continuing to rise significantly, even though housing markets are weakening on both sides of the border. So this is important to monitor in terms of the Bank of Canada making further progress on its inflation objective.”

Gasoline prices saw a steep 9.6% monthly decline in August, but that was offset somewhat by food prices shooting up by 10.8% annually, the fastest pace since 1981. The volatility in those two components, he said, underscores the importance of watching the core measures, which is what the BoC focuses on as it makes rate-hiking decisions.

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While yesterday brought a much-needed small win for Canada’s central bank, Mattina stressed that it will still need external factors to continue trending in its favour.

“We've really benefited in recent months from declining oil and gasoline prices, and a reversal on that front, which will be driven largely by international factors, would really set back the Bank of Canada's progress towards inflation control,” he said. A look at the commodity futures curve shows expected oil price declines of roughly $20 a barrel over the next four years.

The second straight month of declining prices also offers some leeway for the central bank to throttle back; with employment falling over the past three months and pressure mounting on Canada’s indebted households, the BoC every bit of positive inflation data it can get to slow down its policy tightening.

The easing in headline CPI is also good news in that it reduces the risk of inflation psychology getting embedded into wage demands. With the prospects of a wage spiral getting decreasing, there’s even less reason for the central bank to aggressively increase policy rates.

“A less aggressive pace of rate hikes might be appropriate compared to the more recent supersized rate hikes that we've seen in the last couple of Bank of Canada decisions,” Mattina said. “I wouldn't be surprised to see a hike of 50 basis points in October followed by 25 in December.

“I think markets believe the Bank of Canada is credible and getting inflation under control. But it's going to take time, and inflation is high … It could take until the end of next year, or even early 2024 to see inflation solidly within the control zone and back to 2%.”