Inflation’s last mile to Bank of Canada’s 2-per-cent target could be a long and winding road

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After surging to a four-decade high in 2022, the annual pace of inflation in Canada is back within striking distance of the Bank of Canada’s target. The key question now is how long it will take to traverse the final leg down.

Some economists think this last mile, bringing consumer price index inflation from around 3.5 per cent to the central bank’s 2-per-cent goal, will be the hardest.

Most of the disinflation over the past 18 months has come from falling oil prices and improvements in global supply chains. That was the easy part, the argument goes. What’s left of inflation is being driven by domestic forces and concentrated in services, making it harder to tame without an extended period of slow economic growth and rising unemployment.

Other economists, by contrast, think inflation is closer to target than hawkish central bankers are willing to admit.

Economic growth in Canada has effectively stalled since last summer, dampening inflationary pressures. And, excluding high increases in shelter costs – which are partly a result of past interest rate hikes – inflation is already only a few ticks above the bank’s target.

There’s a lot riding on this debate. Bank of Canada officials are no longer actively discussing raising their policy interest rate, which they have held steady at 5 per cent since July, a two-decade high, in a bid to slow the economy and restrain price growth. But they say they won’t contemplate rate cuts until they’re confident inflation is firmly on a downward track from the current level.

Other central banks, including the U.S. Federal Reserve and the European Central Bank, are in similar positions.

“We don’t want to wait until inflation is all the way back to 2 per cent before we start cutting interest rates, because if we did that we would overshoot … we’d cool the economy more than we have to,” Bank of Canada Governor Tiff Macklem told the House of Commons finance committee on Thursday.

“But you don’t want to lower them until you’re sure that you’re really on a path to get there. And that’s where we are right now. We’re looking for that insurance.”

The bank’s latest forecast, published in January, sees inflation hovering around 3 per cent until the middle of the year, then declining to around 2.5 per cent by the end of 2024 and returning to the 2-per-cent target in 2025.

That projection is surrounded by upside and downside risks, which could determine whether the bank starts cutting rates as early as April – providing some relief to mortgage borrowers and others whose costs have been affected by rate hikes – or stays on hold until the summer or even later in the year.

Here’s the state of inflation today, as central bankers lace up for the last mile.

Global factors coming back into line

When inflation took off in 2021 and 2022, it was driven largely by two factors: oil prices and durable goods prices. These components of the consumer price index are now helping pull the rate of inflation back to earth.

After collapsing at the outset of the pandemic, global oil prices rebounded as lockdown measures eased, and surged after Russia’s invasion of Ukraine. The average price for a litre of gasoline in Canada rose from a low of $0.77 in April, 2020, to a peak of $2.07 in June, 2022.

Oil prices have since come down considerably. This has reduced the price Canadians pay at the pump and lowered the cost of a major input for many businesses.

The Bank of Canada’s latest Monetary Policy Report, published in January, projects benchmark Brent crude oil will average around US$80 a barrel over the next two years, down from a peak of around US$120, and US$10 lower than the bank projected in October. “The decline reflects a combination of better-than-expected conditions for supply and weaker-than-anticipated demand for oil,” the bank said in the report.

Durable goods prices followed a similar trajectory. Consumers were unable to spend on in-person services during pandemic lockdowns, and so demand, buoyed by government support cheques, swung toward goods, such as furniture, electronics and exercise equipment.

That put upward pressure on prices and gummed up global manufacturing and transportation networks. There was a pileup of container ships at ports in China and the United States, and a shortage of parts, notably semiconductors. Transportation costs soared and were passed along to customers.

Supply chains have largely normalized since then, as capacity has been added and consumer spending has shifted from goods back to services.

“Inflation is not in the goods sector anymore. Goods have almost gone back to being a source of low inflation,” said Douglas Porter, chief economist at Bank of Montreal. “It really is a services story, and that’s mostly a homegrown issue.”

Recent attacks on shipping in the Red Sea as part of a broadening conflict in the Middle East are once again pushing up shipping costs and raising concerns about supply chain disruptions.

Mr. Porter said he’s not overly worried this will spur a rebound in goods inflation, given that demand has moderated. It’s a different world today than in 2021 and 2022 when there was “a wave of demand washing over a challenged supply chain,” he said.

Shelter inflation remains a key concern

To a large degree, today’s above-target inflation can be blamed on the housing market. The Bank of Canada projects that most of this year’s inflation will come from the shelter component of the consumer price index, which includes mortgage interest, rents, home insurance and electricity.

The Bank of Canada’s rate hikes have led to a surge in the costs of mortgage interest payments, so as the central bank shifts into rate-cut mode, this aspect of inflation should ease, too.

But rising rents are more indicative of the long-standing imbalance between supply and demand in Canada’s housing market – something the Bank of Canada has little control over.

Over the next few years, shelter inflation “is expected to decline modestly and act as a material headwind against the return of inflation to the 2-per-cent target,” the central bank warned in its Monetary Policy Report.

Mr. Macklem recently said that central bankers can “look through” mortgage interest costs to get a better sense of inflation. And indeed, when those costs are excluded, inflation is running just above the bank’s target rate.

The hazard is that in lowering interest rates, the Bank of Canada could wind up throwing fuel on the real-estate market, which has been mired in a long-term slump. A rate cut could also heat up demand for consumer goods that are tied to home-buying activity, such as furniture and household appliances.

There are still inflationary pressures in the labour market

The labour market is cooling, but you wouldn’t know it from looking at wages, which are growing at annual rates in the range of 4 per cent to 5 per cent. For workers, this is welcome relief, after an inflation surge that eroded real wages. For central bankers, it’s a potential headache.

Canada’s labour productivity – that is, economic output per hour worked – has fallen for six consecutive quarters, alongside the rise in employee compensation. Put another way, businesses are paying more for the average worker to produce less.

In the short term, this dynamic doesn’t necessarily lead to higher inflation, the Bank of Canada explained in its latest Monetary Policy Report. Businesses may absorb those higher wages through lower profit margins, or they may find cost savings elsewhere. But if the situation drags on for a while, businesses may pass on higher labour costs to consumers, adding to inflationary pressure.

The latter is precisely what central bankers are worried about. Bank of Canada officials have frequently said that current rates of wage and productivity growth are not consistent with a return to 2-per-cent inflation. Something will need to change, and because Canada has persistent challenges in raising productivity, that likely means a slower pace of wage increases.

“The labour market has come into better balance,” Mr. Macklem recently said. “We are expecting to see wage growth moderate but we haven’t seen that yet.”

Food inflation is normalizing

Canadians hoping for a break on their rising grocery and restaurant bills got a spoonful of disappointment in December, as the annual pace of change in food prices stalled out at 5 per cent after five months of declines.

The worry is that stubbornly fast-rising food prices could interfere with the Bank of Canada’s inflation fight, though economists believe more relief is coming.

Inflationary pressure on food is typically higher in the winter months, because Canada must turn to far-flung locations like California and Mexico for most of its fruits and vegetables, said Mike von Massow, a food economist with the University of Guelph. Those were the only two grocery segments in which prices rose month-over-month in December, a trend he expects to reverse as warmer weather comes.

The biggest driver of food inflation now comes from meals bought at restaurants. Claire Fan, an economist with RBC, said this likely reflects other price pressures, such as wages, which are expected to ease as the job market cools.

American consumers have enjoyed more relief on the food price front than Canadians so far. Annual food price growth there slowed to 2.7 per cent in December, roughly half the rate in Canada – though it’s also true that U.S. food inflation rose faster and peaked earlier than it did here, Ms. Fan said.

The weak loonie is contributing to food inflation pressure by making food imports more expensive.

Meanwhile, Ottawa ramped up its criticism of Canada’s grocery giants last week. Industry Minister François-Philippe Champagne urged the Competition Bureau to carry out a follow-up study of the country’s grocery stores. In a letter to the bureau, he accused the companies of not providing regular updates about their participation in “initiatives aimed at stabilizing food prices.”

Even without further government intervention, economists said most signs point to a further slowdown in food inflation in the coming months.

“The BoC can look at all these things and expect food inflation to keep moderating, even if the progress is choppy,” Ms. Fan said. “That’s not something they can say about rent or shelter, which is a larger sticking point.”

The economy has entered excess supply, but core measures remain hot

More than any single component of the CPI, what guides the Bank of Canada’s decision-making are metrics that capture “underlying” price pressures in the economy. Here, the signals are mixed.

On a three-month annualized basis, the bank’s preferred measures of core inflation, which strip out the most volatile price movements in the consumer price index, have largely been stuck in the 3.5-per-cent to 4-per-cent range for the past year. Mr. Macklem has said repeatedly that he needs to see core inflation measures move sustainably lower before easing monetary policy.

Meanwhile, inflation is becoming less widespread. Around 80 per cent of the components of the consumer price index were rising at more than 3 per cent in 2022. Now it’s roughly half. But that’s still well above normal levels.

To gauge the path of overall inflation, the Bank of Canada is focusing on a handful of metrics: The balance of supply and demand in the economy, wage growth, corporate price-setting behaviour, and consumer and business expectations about future inflation.

On the first point, things are moving in the right direction. The Canadian economy has grown very little over the past six months – although GDP growth appears to have come in stronger than expected in the fourth quarter, according to recent data from Statistics Canada. In January, the central bank said the Canadian economy had moved into a state of “excess supply,” which means the overall supply of goods and services exceeds demand. That should put downward pressure on prices over time.

Still, there has been relatively little progress on the other key metrics.

“To get that [interest rate] pivot soon, in the first half of the year, you pretty quickly need to see some of those things moving in the right direction,” said Taylor Schleich, a rates strategist with National Bank of Canada. “They don’t have to be back to where the BoC ultimately wants them to be. But you’ve got to have confidence that those are moving in the right direction. And right now, frankly, we haven’t seen that.”

Some economists think inflation could prove more stubborn than expected. Derek Holt, head of capital market economics at Bank of Nova Scotia, pointed to a potential surge in real estate prices this spring, rapid population growth and a possible increase in federal and provincial government spending on things such as pharmacare.

Others aren’t as convinced. Stephen Brown, deputy chief North America economist at Capital Economics, said central bankers may be inclined to keep talking tough about inflation. But he said waiting too long to cut rates could be an error that leads to an unnecessary recession.

“Services excluding housing, and core goods inflation, are both at 2 per cent. Food inflation is still high, but we know on a three-month annualized basis, it’s about 2 per cent. Energy inflation shouldn’t be too problematic this year,” he said. “So unless you really think the bank needs to keep the policy rate high because of high rent inflation, I really struggle to understand this case that the bank needs to keep policy very restrictive for much longer.”