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Credit market traders and economists are becoming more convinced that the Bank of Canada will hike interest rates by a further 25 basis points later this month following inflation data this morning.

Money markets are now pricing in a 76% probability of a 25 basis point hike by the central bank on Jan. 25, up from 71% odds prior to the 830 am ET inflation report from Statistics Canada, according to Refinitiv Eikon data. They now see only a 23% chance of the bank holding its overnight rate steady. Markets have virtually priced out odds of a larger 50 basis point hike.

The market started assigning greater odds of a further rate hike this month after a blowout Canadian employment report on Jan. 6, which showed the net creation of 104,000 jobs. Several economists also shifted their forecasts following that report, believing such a strong labour reading will give the Bank of Canada enough motive to tighten monetary policy further.

Today’s inflation report showed inflationary pressures easing more than Street forecasts - but not by much. And core measures remained little changed from the previous month. Canadian bond yields, and the loonie, had little reaction to the data.

A further 25 basis point hike would bring the Bank of Canada’s target rate to 4.50%. Money markets, however, believe the bank will shift to lowering rates by the end of this year as the economy slows. By its December policy meeting of this year, bets in credit markets suggest the overnight rate will be at 4%. Variable rate mortgages and many other credit products are tied to changes in the bank’s target rate.

Inflation slowed to 6.3% in December from 6.8% in November, a notch lower than the 6.4% median forecast of analysts. Prices fell 0.6% from the previous month, versus analysts’ forecast for a 0.5% decline.

Consumers paid 13.1% less at the pump in December compared with November. However, food prices rose 11% on the year in December. The average of two of the central bank’s core measures of underlying inflation, CPI-median and CPI-trim, came in at 5.2% compared with 5.3% in November. Excluding food and energy, prices rose 5.3% in December versus 5.4% in November.

Here’s a snapshot of how economists are reacting:

Douglas Porter, chief economist, BMO Capital Markets

Canadian CPI continues to calm down after last spring’s unnerving sprint. Beyond the plunge in pump prices last month, we also saw a record monthly drop in appliances (-4.1%)—reinforcing the point that the supply chain issues are fading as a driver. Note, though, that services prices are still up 5.6% y/y, warning of some persistence. Pulling some of the underlying strands together, the three-month trend on seasonally adjusted prices, excluding food & energy, eased to a 3.7% annualized pace. That’s less than half the peak hit in May, and the slowest in almost a year. It’s also below the level of short-term interest rates, suggesting that the BOC may indeed be just about done hiking. However, the 12-month trend is still lofty at 5.3% (and most core measures are holding around 5%). And even the much more moderate 3-month pace is still above the top of the BoC’s 1%-to-3% comfort zone, and is at the very high end of trends seen in the two decades prior to the pandemic—topped only by the spike in auto insurance rates back in 2002. Bottom Line: Better, but not yet good.

Leslie Preston, managing director & senior economist, TD Economics

December’s CPI report showed that Canadian inflation continues to come off the boil, but at 6.3% remained well above the Bank of Canada’s 1-3% target. We expect the cooling process to continue, but it will require consumer spending to effectively grind to a halt. ... Despite signs from the consumer and business surveys that Canadians are tightening their belts as they brace for recession, the battle against inflation has not turned enough for the BoC to declare victory. We expect the Bank will make one last quarter point hike next week, and then pause to assess the cumulative impact of a year of dramatic tightening on the economy.

Stephen Brown, senior Canada economist, Capital Economics

Although the annual rates of core inflation remain elevated, the three-month annualized rates of CPI-trim and CPI-median dropped back to 2.5% in December. Elevated inflation expectations mean that the Bank of Canada will probably still raise interest rates further next week, but the CPI data suggest that a smaller 25 basis point hike is the most likely outcome.

Benjamin Reitzes, managing director, Canadian rates & macro strategist, BMO Capital Markets

Headline inflation was soft, as widely expected, due to seasonality and a big drop in gasoline prices. Core inflation eased ever-so-slightly, but the slow pace of improvement will bring little comfort to policymakers. Underlying price pressures remain sticky for now. While the direction of inflation is at least mildly encouraging, there’s nothing in this report to keep the Bank of Canada from hiking rates another 25 bps at next week’s policy meeting.

Karyne Charbonneau, executive director, economics, at CIBC

The good news is that inflation is easing, and that will become more noticeable when the big monthly increases seen this past spring start to drop out of the annual calculation this year. Moreover, core inflation excluding mortgage costs is growing at a pace much closer to target. However, given the strong December job’s report and tightness in the labour market, that likely won’t be enough to deter the Bank of Canada from raising rates 25 bps one last time next week.

Derek Holt, vice president and head of capital markets economics

The case for hiking by 25bps outweighs the case for pausing in my view. But I would advise market participants and funding operations to play it safer. They would be little rewarded beyond puerile bragging rights if the BoC hikes 25 basis points, but potentially get their heads handed to them if the BoC pauses and thus start the calendar year behind the eight ball on their performance. I’m more concerned about the risk to a pause than the reward to adding a few more points to what is an almost entirely priced hike. The reason for this market perspective is that a somewhat erratic central bank that has (unwisely imo) surprised market participants three times in eight meetings over the past year after a wild ride when they blew it in 2021 could easily pick whatever it wants from the arguments and surprise markets again, but this time do so with an unexpected pause. If they hike, so what, add a few basis points to what isn’t priced already pending developments up to game day. The only way I can see further material upside to multi-contract hike pricing out of this decision would be if the BoC sounded like they were significantly leaning toward another hike after hiking next week. They are probably loathe to do so, as evidenced by the could-might-maybe guidance they provided through communications in December. But if they do pause, then markets would not only take out the priced hike in terms of what it means to, say, 2-year and 5-year GoC yields, but would also probably have their ‘gotcha’ moment. That could be expressed as piling into the front-end on the first sign of a wavering central bank that’s signalling the end of the hike cycle and by raising the probability and magnitude of cut pricing later in the year. I don’t think that risk should be courted by the central bank, but there have been times when the BoC does not necessarily consider the market implications in my view.

Matthieu Arseneau and Alexandra Ducharme, economists with National Bank Financial

This morning’s data does not change our view that the Bank of Canada should consider a pause following the extremely aggressive tightening orchestrated in 2022. The actions taken so far will continue to dampen economic activity in the quarters ahead and, consequently, inflationary pressures. GDP and labour market has remained healthy until the end of 2022, but the economic outlook is darkening if the Business Outlook Survey is any guide. No less than 30% of corporations are expecting a drop in their volume sales, a record high excluding recession.

Caution is also necessary given that recent developments are encouraging, suggesting further moderation in price pressures. Higher inventories compared to earlier during the pandemic, significantly lower transportation costs, sales price cuts by Chinese producers and the global economic slowdown suggest a lull on the goods side. According to Ivey PMI, a gauge for the manufacturing sector and upstream inflation pressures, suppliers’ delivery time and prices all suggest significant improvement in the global supply chain corroborated by the Business Outlook Survey published yesterday. For services, the return to normal inflation levels may take a bit longer, but there is reason to believe that labour market will loosen up in a weak growth environment, contributing to a reduction in wage pressures.

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