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Inflation

Inflation hits 2-year Low Due to Base Effects

Inflation hits 2-year low due to base effects, but unlikely to prevent another Bank of Canada rate hike

As predicted, Canada experienced a decline in its headline Inflation rate in May, reaching a two-year low. The decrease can be attributed to significantly lower gasoline prices compared to the previous year.

According to a recent report by Statistics Canada, the annual consumer price index (CPI) dropped to 3.4% in May, down from April’s 4.4%. This represents the slowest increase since June 2021.

The core inflation rate, which excludes volatile food and energy prices, also decreased. The CPI-trim fell to 3.8% in May from 4.2% in April, while the CPI-median eased to 3.9% from 4.3%. The Bank of Canada’s preferred measure of core inflation, the three-month annualized increase, remained at 3.85% for Trim and slowed to 3.6% for Median. However, both figures remain well above the Bank of Canada’s target of 2%.

Bank of Canada still expected to hike rates (inflation) in July

Despite the slowdown in price growth indicated by the latest inflation data, observers believe there are still inflationary pressures in certain sectors of the economy. Consequently, the possibility of another rate hike by the Bank of Canada in July remains open.

Leslie Preston of TD Economics noted that although Canadian inflation has cooled, it is unlikely to deter the Bank of Canada from raising rates next month. Core inflation, particularly in the services sector, shows slow improvement, with inflation rising in discretionary areas such as travel services and restaurant meals (6.8% year-on-year in May).

Benjamin Reitzes from BMO also agrees, stating that core inflation has not shown signs of a sustainable slowdown and remains too high for the Bank’s liking. While the odds of a July rate hike might be slightly lower now, a hike still seems likely if the upcoming data supports it.

Bond markets are currently pricing in a 58% probability of a rate hike in July and a 94% probability of a hike by September.

Mortgage interest costs remain the largest contributor to inflation

The data also revealed that mortgage interest costs have become the largest contributor to overall inflation due to the Bank of Canada’s rapid rate hikes in the past year. Excluding higher mortgage costs, inflation would have been at 2.5% in May. The sub-component of mortgage interest costs saw an annual increase of 29.9% in May, up from 28.5% in April.

Recent data from Statistics Canada indicates that actual mortgage interest costs in dollar terms have risen nearly 70% over the past year, despite the per capita index showing a year-over-year increase of nearly 30% as of the first quarter.

In conclusion, Canada’s inflation rate decreased in May, primarily driven by lower gasoline prices. However, inflationary pressures persist, and a rate hike by the Bank of Canada in July is still a possibility. Mortgage interest costs continue to contribute significantly to overall inflation, demonstrating the impact of recent rate increases.

Annual increase in mortgage interest cost Inflation

What are base effects?

Base effects refer to the influence of price movements from the previous year on the current month’s Consumer Price Index (CPI). It is a term used to explain the impact of large price changes in the base month on the year-over-year price movement.

When there is a significant upward price change in the base month that is no longer affecting the 12-month price movement, it has a downward effect on the current month’s headline CPI. Conversely, if there was a substantial downward price change in the base month that is no longer included, it creates upward pressure on the current month’s annualized figure.

In the case of Canada’s inflation, the first half of 2022 saw a notable price increase for consumers due to the Russian invasion of Ukraine. This resulted in headline consumer inflation rising from 5.1% in January to 8.1% in June 2022.

As time passes and the price increases observed in the first half of 2022 are no longer factored into the 12-month price movement, the rate of inflation has slowed in recent months. However, it’s important to note that prices still remain elevated, indicating that inflationary pressures persist.

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