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People shop in a grocery store in Montreal on Nov. 16, 2022. Canada's rate of inflation slowed in September, rising 3.8 per cent last month from a year earlier, down from 4 per cent in August.Graham Hughes/The Canadian Press

Canada’s inflation rate unexpectedly dipped in September, a sign that higher interest rates are having their intended effect and that the Bank of Canada may not need to raise them further.

The Consumer Price Index rose 3.8 per cent last month from a year earlier, down from 4 per cent in August, Statistics Canada says in a report released Tuesday. Analysts on Bay Street were expecting the inflation rate to remain at 4 per cent. Unadjusted for seasonality, the CPI fell 0.1 per cent on a monthly basis.

The Bank of Canada has warned that bringing inflation back to its 2-per-cent target could be a bumpy ride, and that’s proven to be the case. After easing to 2.8 per cent in June, the annual inflation rate climbed over the summer, largely because of rising energy prices.

Now, inflation is back on a downward trajectory. Higher interest rates are weighing on consumption across the economy, while gasoline prices have fallen in recent weeks. Economists said the October CPI report should bring another decline in the inflation rate.

Tuesday’s report had a significant effect on expectations for monetary policy. Bond yields tumbled after the release, while financial markets priced in weaker odds the Bank of Canada would raise its benchmark interest rate by a quarter-point on Oct. 25, its next decision date.

Thus far, the bank has raised its key rate to 5 per cent – the highest since 2001 – from crisis lows of 0.25 per cent, the quickest pace of tightening in decades. This shift in lending conditions is putting pressure on household and government finances, while economic growth has stagnated in recent months.

Live updates: Canada annual inflation rate edges down to 3.8% in September

But there may not be further need for action. After the CPI report, some analysts said the Bank of Canada was likely finished raising interest rates for this cycle.

“Given that inflation is the most lagging of indicators, and the economy is clearly weakening, we’re likely to see ongoing disinflationary pressure,” Benjamin Reitzes, a Bank of Montreal strategist, said in a client note. “There’s no need for further rate hikes in Canada.”

There were widespread improvements in September. Grocery prices rose 5.8 per cent on an annual basis, down from 6.9 per cent in August. At peak levels, grocery inflation was running at more than 11 per cent. This deceleration was foreshadowed by weaker price increases – or even declines – at earlier stages of the food supply chain.

Over the past year, prices have risen 4.4 per cent for meat, 4 per cent for dairy products and 2.7 per cent for coffee and tea. However, Statscan cautioned those prices were being compared with a spike last year, a “base-year effect” that is leading to more subdued numbers.

“The slowing trend in food price inflation is expected to continue through at least the turn of the year and likely into 2024,” Mr. Reitzes said.

Supply chain issues appear to be firmly in the rearview. Prices for durable goods, which were heavily exposed to supply disruptions, rose just 0.4 per cent in September from a year earlier, down from 1.4 per cent in August. Goods related to the beleaguered housing sector – such as furniture and appliances – are declining in price.

The travel industry had an outsized effect on the September numbers. Airfare prices fell 21 per cent, which Statscan attributed to an increase in available flights.

Still, there are some pesky aspects of inflation. Housing costs rose 6 per cent in September, matching the annual gain seen in August. Rents jumped 7.3 per cent in September, up from 6.5 per cent the previous month, a sign of how Canada’s housing shortage is affecting the numbers.

But overall, inflationary pressures are abating. The Bank of Canada’s preferred measures of core inflation, which strip out volatile movements in the CPI, slowed in September. Excluding food and energy, the CPI rose 3.2 per cent on a year-over-year basis, down from 3.6 per cent in August.

Royce Mendes, head of macro strategy at Desjardins Securities, said around 40 per cent of items that are part of the CPI were experiencing inflation of 5 per cent or higher – down 10 percentage points from August.

“The slowdown in most measures of inflation combined with the lower volatility across categories should easily give the Bank of Canada enough confidence to hold rates next week,” he wrote in an investor note.

Interest rate swaps, which capture market expectations about monetary policy, are pricing in a 15-per-cent chance that the Bank of Canada hikes interest rates by a quarter-point, down from 42 per cent before the inflation report was released.

Alongside its rate decision, the bank will publish its quarterly Monetary Policy Report next week, which includes its forecast for economic growth and inflation. The bank expects a return to 2-per-cent inflation by mid-2025, although this is subject to change in the updated projections.

“Canadian consumers can breathe a sigh of relief, firstly because inflation appears to be easing again and secondly because that deceleration diminishes the chances of further interest rate hikes from the Bank of Canada,” Andrew Grantham, senior economist at CIBC Capital Markets, said in a research note.

“While inflation is admittedly still well above target, there were signs within today’s release that the weakening of domestic demand is now starting to impact pricing in some areas and should continue to do so moving forward, without the need for further interest rate hikes.”

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