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The Bank of Canada building in Ottawa. The central bank is widely expected to raise interest rates in the coming months as inflation remains above its target rate.Chris Wattie/Reuters

Canada’s annual inflation rate dropped by a percentage point in May, but the path to restore price stability could be challenging as the costs of some goods and services continue to rise at elevated rates.

The Consumer Price Index rose 3.4 per cent in May from a year earlier, down from 4.4 per cent in April, Statistics Canada said Tuesday in a report. It was the lowest inflation rate in two years. The slowdown met analysts’ expectations on Bay Street. Adjusted for seasonality, the CPI rose 0.1 per cent on a monthly basis.

Despite that progress, the Bank of Canada is widely expected to raise interest rates again in the coming months, and perhaps as soon as July. Its policy rate of 4.75 per cent is the highest since 2001.

The May inflation numbers benefited from favourable comparisons with a year ago, otherwise known as base-year effects. Commodity prices surged after Russia’s invasion of Ukraine in early 2022, but those initial effects are no longer part of the year-over-year calculation of consumer price inflation.

For instance, gasoline prices – which peaked in the late spring of 2022 – fell 18.3 per cent on an annual basis.

Still, inflation is proving tricky to tame. The short-term trend for various measures of core inflation – which strip out volatile components of the CPI – is tracking just below 4 per cent, when expressed at annualized rates.

The Bank of Canada has expressed concern that inflation could get stuck materially above its 2-per-cent target. This prompted the central bank to raise its policy rate to 4.75 per cent from 4.5 per cent earlier this month, ending a brief pause to changes in monetary policy.

“It looks almost like a done deal that the Bank of Canada will raise rates” again in July, said Royce Mendes, head of macro strategy at Desjardins Securities, in a note to clients. “The sticky inflation data builds a strong case for further monetary tightening.”

Grocery costs are still climbing at robust rates. Prices rose 9 per cent in May on an annual basis, barely changed from 9.1 per cent in April. The prices of bakery products rose 15 per cent, while those for cereal products jumped 13.6 per cent. Price growth also accelerated at restaurants.

In a report published Tuesday, the federal Competition Bureau said the country needed more competition in the grocery sector to improve products and help lower prices.

Mortgage interest costs rose almost 30 per cent from a year earlier. The Bank of Canada’s rate-hike campaign is having a significant impact on this area of the CPI, particularly as homeowners renew their mortgages at higher rates or dedicate more of their monthly payments to the interest portion rather than paying down principal.

Instant reaction: Money markets pare back odds of July rate hike after Canada inflation data

Excluding mortgage interest costs, the CPI rose 2.5 per cent annually in May, down from 3.7 per cent in April.

Canada’s affordability crisis is adding more pressure to the rental market, which saw prices rise 5.7 per cent in May from a year earlier.

There is, however, major progress in some industries. Prices for durable goods rose 1 per cent in May on an annual basis, slowing from 2.2 per cent in April, as supply chains return to more normal operations. Prices for furniture fell 2.9 per cent, the most since the early stages of the pandemic.

The Bank of Canada is aggressively raising interest rates to tamp down demand and bring inflation under control. However, consumer spending has remained exceptionally robust. This, along with other strong economic data, convinced the bank that monetary policy was not restrictive enough to subdue CPI growth.

The bank’s governing council “felt that a broad range of indicators had increased their concern that the disinflationary momentum needed to bring inflation back to the 2% target could be waning,” read a summary of deliberations for the rate hike on June 7.

Back in April, the bank projected that annual inflation would fall to about 3 per cent in the summer months before declining to the 2-per-cent target in late 2024.

Andrew Grantham, senior economist at CIBC Capital Markets, said inflation could soon fall below 3 per cent.

“However, inflation could accelerate slightly again after that, particularly if food prices continue to climb, and as the base effects from energy prices become less favourable,” he wrote in a research note. “Overall, today’s data don’t change the fact that inflation is running hotter” than the bank estimated in April.

The Bank of Canada will publish updated economic projections at its next rate decision, on July 12. Financial analysts are leaning toward a quarter-point hike at that time, taking the policy rate to 5 per cent. Some analysts on Bay Street think the increase will take place in September.

“Every inflation metric remains far above the 2-per-cent inflation target,” Benjamin Reitzes, a rates and macro strategist at Bank of Montreal, said in a client note. “Accordingly, Bank of Canada policy makers won’t breathe a huge sigh of relief after this report as core inflation remains sticky and has yet to show signs of a durable slowdown.”

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