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Headline inflation numbers in Canada this morning for May matched expectations, but some signs of improvement in core inflation readings have money markets seeing modestly decreased odds of a further Bank of Canada rate hike next month.

Several economists also suggest the pressure may be easing on the central bank to tighten monetary policy any further - although not all agree.

Canada’s annual inflation rate slowed to 3.4% in May, driven by a drop in gasoline prices, while mortgage interest costs remained high, Statistics Canada data showed on Tuesday. Month-over-month, the consumer price index was up 0.4%, below forecasts of a 0.5% rise.

The annual rate, which benefited from a comparison to last May’s strong price increases, is the slowest since June 2021 and broadly in line with the Bank of Canada’s expectation that inflation would cool to around 3% by mid-2023.

The average of two of the Bank of Canada’s core measures of underlying inflation, CPI-median and CPI-trim, came in at 3.9% compared with 4.3% in April.

The Canadian dollar and bond markets had minimal reaction to the 830 am ET inflation data, with the five-year government bond yield last quoted at 3.734%, up a couple basis points but well below the 15-year high of 3.896% last week and a more modest rise than its U.S. counterpart on Tuesday. The five-year bond yield influences fixed mortgage rates as well as some guaranteed investment certificate terms. The Canadian dollar dipped slightly against its U.S. counterpart following the data but soon recovered.

Interest rate probabilities based on trading in swaps markets now show about a 57% chance that Bank of Canada will hike rates by another quarter of a percentage point at its next policy meeting on July 12. That’s down from about 64% prior to the data.

Here’s a detailed look at how money markets are pricing in further moves in the Bank of Canada overnight rate, according to Refinitiv Eikon data. The current Bank of Canada overnight rate is 4.75%. While the bank moves in quarter point increments, credit market implied rates fluctuate more fluidly and are constantly changing. Columns to the right are percentage probabilities of future rate moves.

Prior to the 8:30 am ET data:

Meeting DateExpected Target RateCutNo ChangeHike

And here’s where things stood by 9 am ET:

Meeting DateExpected Target RateCutNo ChangeHike

As for economists, here’s how they are reacting:

David Rosenberg, founder of Rosenberg Research

This was a highly encouraging report and should allow the Bank of Canada to sit out the next meeting, especially now that the major surveys are flagging a turndown in employment. Excluding the 8 most volatile components and indirect taxes, the CPI again eked out a modest +0.2% advance last month. The key number for the BoC, such as the median core index (+0.2% and has been +0.3% or lower in each of the past four months) slowed to +3.9% year-over-year from +4.3% in April (consensus was +4.0%). ...

It has to be said that in the most bizarre way, the BoC itself is contributing to “inflation” via its rate hikes! How ironic is that? And that is because Statistics Canada includes mortgage interest costs in the CPI and that accounts for 4% of the index and a 5% share of the core. There is nothing in the data more inflationary than this! Mortgage costs are up an epic +30% year-over-year! This is a record by any stretch. If we were to exclude this from the headline, the CPI inflation rate would now be 2.5% (not so far away from the holy grail target of 2.0%) instead of the 3.4% reading. The MoM reading, seasonally-adjusted, would have been flat absent the mortgage rate shock. And the “core” inflation measure excluding mortgage interest costs rings below 3.0% as well (the MoM print was +0.1%).

The bottom line is that disinflation in Canada is showing progress, and much more when assessing the data beneath the headline. The only issue is whether this progress is fast enough for the Bank of Canada that recently has lost its patience. Maybe it’s time for Macklem to pick up the Rudyard Kipling classic “If” and start to keep a cool “head” as he did back in the late winter and early spring.

Andrew Grantham, executive director, Economics, CIBC Capital Markets

While inflation was no weaker than the consensus expectation in May, some signs of tamer core price pressures could provide a bit of breathing space for the Bank of Canada as it decides if, or when, to raise interest rates again. Headline prices rose by 0.4% in May (not seasonally adjusted) for an annual rate of 3.4%. The year-over-year rate was a deceleration from 4.4% in the prior month, although that was mainly due to base effects from gasoline prices, as last May represented close to peak prices at the pumps. Food price increases remained stronger than those seen stateside. ... The good news in today’s release came from slightly softer core measures of inflation. CPI excluding food/energy rose by 0.2% seasonally adjusted, and excluding mortgage interest costs as well the 3-month annualized rate decelerated to 2.8% (having spiked up to 3.4% in April). While the Bank of Canada’s preferred core measures continue to run hotter, at 3.9% and 3.8% y/y for median and trim respectively they were at least slightly below consensus expectations. Overall, today’s data don’t change the fact that inflation is running hotter than the Bank’s prior April Monetary Policy Report forecasts. However, the tamer core readings suggest that policymakers may be able to wait a little longer rather than following up June’s hike with another move as early as July.

Stephen Brown, deputy chief North America economist, Capital Economics

While the steep declines in both headline and core inflation in May were partly due to favourable base effects, the monthly gains in each also slowed compared to April. That probably won’t be enough to persuade the Bank of Canada to stand pat at its meeting next month, but it does add to our sense that the Bank will not be forced to raise interest rates beyond 5.0%, implying just one more 25 bp hike. ....

The Bank will still be pleased to see that the CPI rose by just 0.1% m/m this May and that the monthly gains in CPI-trim and CPI-median each slowed to 0.2%. The 1.1% m/m seasonally adjusted fall in transportation prices cannot be explained by the small fall in gasoline prices alone, with the press release suggesting that vehicle prices also declined amid improving supply. Clothing & footwear and household operations, furnishings & equipment prices also fell, which may also be related to improving supply chains. Despite the recent rebound in house prices, the monthly change in shelter prices slowed to 0.4%, from 0.6%, which probably reflected a smaller contribution from mortgage interest costs following the Bank’s earlier pause in rate hikes.

The Bank should be encouraged by the May CPI report, particularly given concerns that the new CPI weights incorporated last month – which boosted the weights of services at the expense of goods – could have caused core inflation to come in higher than expected. With the labour market also loosening in May, the case for another rate hike in July is not quite as strong as it seemed a few weeks ago. Nonetheless, with even the one-month annualised CPI-trim and CPI-median inflation rates still above 2%, and the housing market heating up, we still judge that another hike is more likely than not.

Royce Mendes, managing director & head of macro strategy, Desjardins Capital Markets

Don’t be fooled by the sharp drop off in the headline inflation rate; underlying consumer prices growth is still running at a heady pace in Canada. The 12-month rate of total inflation declined from 4.4% to 3.4% mostly because current energy prices are now being compared to the peaks of 2022 in the annual rate calculation. Indeed, prices rose 0.4% in unadjusted terms and 0.1% after adjusting for seasonality, which still leaves the three-month annualized rate of headline inflation running at 6.6%. Food prices were once again driving the index higher in May, although energy prices took a bit of a breather after a couple of months of gains. Statistics Canada did note that there was a slight upward bias in the data from the changes to basket weights, but we don’t believe that changes the narrative much, particularly because these numbers were all in line with consensus estimates.

Excluding food and energy, the deceleration in year-over-year inflation looked more modest. The 12-month rate of change in that core index fell from 4.4% to 4.0%. While that’s the slowest pace since February 2022, further progress could be hard to come by. In seasonally-adjusted terms, the ex-food and energy index rose 0.2% in May alone, leaving the three-month annualized rate tracking 3.6%, well within the range it’s been in since last year. ...

The three-month annualized rates of the Bank of Canada’s preferred core measures also showed little progress towards bringing inflation to heel. The core median indicator decelerated just two ticks, from 3.8% to 3.6% in seasonally-adjusted terms, while the trimmed mean measure slowed just one tick to from 3.9% to 3.8%. The central bank’s newest tracker, core services excluding shelter, actually accelerated from 4.7% to 4.9%.

With measures of recent price growth continuing to run above 3 ½%, it looks almost like a done deal that the Bank of Canada will raise rates another 25bps in July. The sticky inflation data builds a strong case for further monetary tightening, which was bolstered by a series of hot flash estimates on retailing, wholesaling and factory activity. That said, the market was already well positioned for another rate hike in July, so there’s been little reaction in yields. If anything, the yields are declining slightly given the lack of any upside surprise which would have suggested that the central bank had much more work to do.

Derek Holt, vice-president, Scotiabank Economics

Canadian inflationary pressures sharply ebbed at the margin and this gives the Bank of Canada a little more breathing room to potentially spread out possible further tightening. I would still hike in July if it were me and given continued upside risk to trend inflation, but the BoC’s emphasis upon intermeeting data dependence and lessons on the fine tuning stages in the past make me doubtful at this point that Governing Council will go back-to-back. Significant revisions to core price pressures at the margin lend caution to being overly reliant upon the first swings at the data.

Our forecast remains for a 25bps hike in Q3 but we have positioned the call over July versus September as being highly data dependent. At the margin, this data tentatively leans against July.

There is clear precedence for how BoC policy adjustments do not have to go in a straight line with back-to-back steps. Intuitively this is appealing when the policy rate is already well into restrictive territory and uncertainty is elevated, but this intuition is backed up by past examples since then, such as skipping a hike in September 2018 along a hiking path, or skipping a cut in March 2015 in between a pair of reductions.

In terms of domestic information impacting the call, I still want to see the full suite of data before the July decision, including Friday’s BoC surveys, Friday’s April and May GDP estimates and then the following Friday’s jobs and wages, but at this stage even post-CPI pricing for a July hike seems high to me.

High data dependence is nevertheless confronted by trend upside pressures on inflation risk. The economy remains well into excess demand with no real progress away from this as incremental pressures build.

I don’t see the Fed as necessarily impacting the BoC’s decision next month. This morning’s US macro data was very strong across the board in terms of durable goods orders, as massive 12.2% m/m lift to new home sales, a much larger than expected jump in consumer confidence and a nearly 1% jump in repeat sales home prices for the second straight monthly gain. While this is not first tier inflation or jobs data, it lends itself toward an impression that the US household sector is handling rate hikes rather well to date and given other influences like job markets and the overall state of US household finances.

The evidence today supports a Fed hike in July, but the BoC’s decision to hike in June while the Fed whiffed gave the Canadian central bank a bit of breathing room.

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

Core inflation came on the soft side, with the seasonally-adjusted Trim and Median measures both up 0.2% m/m. That’s a three-month low for Trim and a nine-month low for Median. The softer monthly advances cut the year-over-year rates to 3.8% for Trim and 3.9% for Median, both 4 ticks lower than the prior month. The 3-month annualized increase for Trim was steady at 3.85%, while the Median slowed to +3.6%. Despite the slight improvement in the latter, both metrics remain well above the BoC 2% target and have been stuck in the 3.5%-to-4% range for the past 9 months. Note that CPIX, old core CPI, rose 0.4% m/m, also cutting the yearly rate 4 ticks to 3.7%. That’s still too hot as well with the 3-month annualized rate sitting at 4%. No matter how you slice it, inflation remains a serious issue for the BoC.

Key Takeaway: While the softer-than-expected core prints are a bit of good news, every inflation metric remains far above the 2% inflation target. Accordingly, Bank of Canada policymakers won’t breath a huge sigh of relief after this report as core inflation remains sticky and has yet to show signs of a durable slowdown. The odds of a July rate hike might be slightly lower now, but if the rest of the data hold up over the next 2 weeks, a hike still looks likely.

Leslie Preston, managing director & senior economist, TD Economics

Canadian inflation continued to cool in May, but progress is unlikely to be enough to prevent the Bank of Canada from raising rates in July. Improvements in core inflation are slow, particularly on the services side, with inflation picking up in discretionary areas like travel services and restaurant meals (6.8% y/y in May). Cooler goods inflation is welcome, but the BoC has likely been counting on that already as supply chain snarls improve.

Looking at the Bank’s core measures, Governor Macklem may have a Bon Jovi earworm, humming, “whoa, we’re half way there…”. But, there is still a ways to go to get inflation all the way back to 2%. And the bank would rather not be “livin’ on a prayer”, and is likely to take rates another quarter point higher in July to ensure demand, and hence price pressures cool further.

Matthieu Arseneau and Alexandra Ducharme, economists with National Bank Financial

The trend in annual inflation is welcome and should improve further next month as the spectacular spike in June 2022 is removed from the calculation (negative base effect). While inflation could be back within the Bank of Canada’s target range as early as June, the Bank has expressed concern about a sustained return to the midpoint of the target. This prompted the Bank of Canada to resume its policy rate hikes earlier this month. In this respect, May’s core inflation data may allay some of its fears. After a spike in April, the average of the CPI-trim and the CPI-median was 0.22% during the month (m/m %), the smallest increase in 9 months. We continue to question the need to resume interest rate hikes in Canada. Since then, the employment data showed the first signs of weakness and the monthly inflation trend returned to a more desirable pace. We continue to expect a marked slowdown in economic activity over the coming months, in a context in which the real interest rate is now the most restrictive since 2009. This should be sufficient to ease wage pressures in the Canadian economy, while deflation in the prices of global manufactured goods should eventually translate into lower prices for consumers.

Jay Zhao-Murray, forex analyst at Monex Canada, a commercial foreign exchange specialist

The breadth of inflation fell, with around half of the components running above target in May, compared to roughly three-quarters when averaged over the past three months. This could be an early sign of cooling price pressures after months of re-acceleration, but the fact remains that the monthly pace of price increases was still twice as strong as it would be if inflation were back to normal and the underlying core measures remain too high for comfort. For this reason, we do not think this single improved report is enough to prevent the Bank of Canada from hiking rates again in July, but it reduces the risk that they will take the overnight rate above 5%. This merely confirms our view on the BoC’s implied rate path, with the risk of inaction at July’s meeting now centred on the data released over the next two weeks.

Claire Fan, analyst, RBC Capital Markets

The ‘headline’ inflation rate is likely to fall further in June – potentially down to the top end of the Bank of Canada’s 1% to 3% target range – as energy prices this year continue to compare to very high year-ago levels. Beyond that, further slowing in broader inflation readings all the way back to the 2% target will be much harder to come by. ...

Although slowing, underlying inflation trends in Canada are still running well-above the BoC’s 2% target. Higher interest rates are cutting into household purchasing power, but spending to -date has been firm. Labour market conditions are also more resilient than expected in 2023 to-date. GDP data and the BoC’s own Q2 Business Outlook Survey later this week will be watched closely for signs that the economy is losing momentum. But absent a large downside surprise from those data releases, we continue to expect the bank to hike the overnight rate by another 25 bp in July, before stepping back the sideline for the rest of this year.

Philip Petursson, Chief Investment Strategist, IG Wealth Management:

“Canadian CPI came in as expected this morning at 0.4% month-over-month and 3.4% year-over-year. While this marks a significant drop in the year-over-year inflation from 4.4% to 3.4% one month to the next, the drop was largely attributed to rolling off last May’s much higher month-over-month inflation of 1.4%. We expect June to show a similar drop that should see headline inflation fall closer to 3%. From that point on we see inflation trending higher again to above 4% through the last half of 2023. This is the challenge that the BoC faces. The “sticky” inflation narrative is going to prove a real problem for the BoC. We don’t see inflation going back to 5-6-7% but at the same time, it is going to take time to get inflation back near 2%. No doubt the BoC sees this as well and this is what fed into their more hawkish statement last month and will likely lead to a further rate increase in July with the potential for additional rate increases in the fall.

The unintended consequence may likely lead to a higher value for the loonie against the US dollar. Canadians should not expect a reprieve on rates until 2024 at the earliest. Sticky inflation between 3-4% and higher interest rates will be the norm for a while yet.”

Bryan Yu, chief economist, Central 1 Credit Union

We thought the June rate hike was unnecessary and more patience from the Bank was warranted given the lags of rates on the real economy. May’s CPI deceleration suggests pressures are indeed easing. Nevertheless, inflation (core and otherwise) is arguably still too high for the Bank to be comfortable, and given its June decision, another hike is still likely in July.

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