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The Bank of Canada is heading into its Jan. 25 interest-rate decision with a different watchword: “data dependence.”

Over the past eleven months, the central bank has pushed its policy rate up to 4.25 per cent from 0.25 per cent with single-minded determination. The question wasn’t whether it would increase borrowing costs at each meeting, but by how much.

Now, with interest rates firmly in restrictive territory and inflation trending down, Bank of Canada officials have turned off autopilot and are poring over economic data for signs of whether it’s time to hit pause on monetary-policy tightening.

“If we are surprised on the upside, we are still prepared to be forceful,” deputy governor Sharon Kozicki said in December, after the latest half-percentage-point rate increase.

“But we recognize that we have raised interest rates rapidly and that their effects are working their way through the economy. In other words, we are moving from how much to raise interest rates to whether to raise interest rates.”

Data published since the December rate decision – including stubbornly high core-inflation numbers from November and a blowout December jobs report – suggest that the Canadian economy has more momentum than the bank would like to see. That increases the odds of another rate hike, and financial markets are pricing in a quarter-point move on Jan. 25.

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But there are still several crucial economic releases coming this week. And for the first time in nearly a year, another rate increase isn’t a sure thing.

“There are two risks right now,” said Avery Shenfeld, chief economist of Canadian Imperial Bank of Commerce.

“One is that they’re not patient enough to see the impact of the hikes they’ve done, and they end up over-hiking and causing a deeper recession than they intended. But there’s also a risk of waiting too long to hike again and finding that inflation reaccelerates. So it’s a balancing act and they’re at the point of the cycle where a finely tuned judgment is required.”

Here’s what the central bank will be watching as it plans its next move.

Inflation

After hitting a four-decade high of 8.1 per cent in June, the annual rate of consumer-price-index inflation had fallen to 6.8 per cent in November. Economists expect to see a further drop in the December inflation data, which will be published Tuesday.

Gasoline prices have fallen sharply since the summer, plunging another 13 per cent month over month in December. Meanwhile, goods prices are levelling off thanks to supply chain improvements and falling shipping costs.

But many service prices continue to rise rapidly. And core inflation, excluding food and energy, is proving sticky. Central-bank officials say they’re paying particularly close attention to three-month rates of core inflation.

“In the second half of 2022, inflation has very clearly receded, so looking at a 12-month number isn’t giving you an accurate indication of what inflation pressures are right now,” said Taylor Schleich, director of economics and strategy at National Bank Financial.

“Those three-month indicators that they’ve highlighted have come down very substantially,” he said. “We were at 7 or 8 per cent in May or June, and now we’re around 3 to 4 per cent.”

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Inflation expectations

The Bank of Canada doesn’t just look at inflation data; it looks at what Canadian consumers and businesses believe about inflation. These beliefs can drive wage negotiations and price-setting decisions.

The key data on inflation expectations will be published Monday, with the release of the Bank of Canada’s quarterly business and consumer surveys. Over the past year, both surveys have consistently found that individuals and companies expect inflation to remain well above the bank’s 2-per-cent target for several years to come.

There were, however, some positive signs in the last Business Outlook Survey, published in October. The average respondent expected 4.26-per-cent inflation in two years’ time, down from 4.8 per cent in the previous quarter. Companies also reported improvements in their supply chains, and lowered their expectations, on average, about future wage increases – two signs that inflationary pressures may be easing.

Labour markets

So far, the most compelling argument for another rate hike comes from the December jobs report, published by Statistics Canada earlier this month. Canada added 104,000 jobs in December, far more than the consensus forecast of 5,000 jobs among Bay Street analysts. The unemployment rate dropped to 5 per cent from 5.1 per cent, leaving it only a notch above the record low.

The remarkable strength of the job market is good news for many workers. But it’s a problem for the Bank of Canada.

Low unemployment and high demand for workers fuels wage growth, which can feed into inflation, particularly in the service sector, as companies increase prices to cover rising labour costs. Governor Tiff Macklem has argued that unemployment needs to rise to get inflation back to target.

“We are starting to see some improvements in the balance in the labour market. Vacancy rates have come down,” Mr. Macklem said at a December news conference. “But we continue to see tight labour markets, we continue to hear from businesses that they’re having trouble hiring the workers they need.”

Economic growth

Ultimately, the Bank of Canada is trying to engineer a general slowdown in the economy to bring demand for goods and services back in line with supply. The challenge is that monetary-policy tightening works with a considerable lag, making it impossible for the bank to judge the impact of rate hikes in real time.

“Inflation indicators are actually not quite as important as growth indicators,” said Mr. Shenfeld of CIBC. “If they see the economy slow enough, they will trust that that will bring inflation down over time. And they’ll be watching things like employment and retail sales and the housing sector for signposts of that.”

Data on November retail sales and December housing starts will be published this week. The bank is also putting more emphasis on high-frequency data, such as restaurant and hotel bookings and public-transit usage.

“When interest rates were 2 per cent, they didn’t need such a fine sieve to look at the economic data, because they were confident that the economy still had a lot of momentum,” Mr. Shenfeld said.

“The closer they get to shutting off the rate hikes, the more they’ll have to look at every bit of information coming in the door.”