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Cab drive Omar Mohamed fills his car with gas at an Esso gas station on King Street West in Toronto. (The Globe and Mail)
Cab drive Omar Mohamed fills his car with gas at an Esso gas station on King Street West in Toronto. (The Globe and Mail)

Inflation rise an ominous sign for interest rates Add to ...

Sky-high gas prices in May helped push inflation to its fastest annual rate in eight years, serving as a reality check for investors and economists that had written off the chance of an interest rate hike before the end of the year.

Spurred by an almost 30 per cent increase in gas prices from a year earlier, the consumer price index advanced 3.7 per cent from May of 2010, Statistics Canada said, faster than April's 3.3-per cent pace and well past the upper limit of the Bank of Canada's comfort zone. Even the core rate, which strips out volatile items such as fuel and fresh foods, quickened to a 1.8 per cent annual pace and threatens to eclipse the bank's 2 per cent target sooner than policy makers were anticipating.

The hotter-than-expected readings suggest that unless the current soft patch in the global recovery becomes entrenched, borrowing costs won't stay as low as they are for very long. The Canadian dollar gained as much as 1.2 per cent against its U.S. counterpart, its biggest intraday gain since December, after the inflation report came out, as investors who had priced out the possibility of a rate hike before next year revised those bets.

"The bank's eye will still be on the inflation ball, even though some near-term numbers are likely to come in weak," said Emanuella Enenajor, an economist with CIBC World Markets in Toronto. "That will keep the bank cautious, not tightening too quickly, but we continue to expect price pressures to move up and we're likely going to see core inflation right around their target" by the third quarter.

Should price gains meet the bank's target by that time, it would be at least six months sooner than policy makers predicted in a forecast published in April, and it would suggest that the slack in the economy will be absorbed sooner than the central bank's mid-2012 projection.

Still, although inflation has been on a tear not seen since early 2010, just before the central bank raised rates at three consecutive decisions, many economists question whether the trend can continue. Gas prices are already coming down, and tapped-out consumers are expected to retrench in the coming months as they try to whittle down their debts. Plus, Mr. Carney has said that while he is looking for an opportunity to start lifting his benchmark interest rate from the current 1 per cent, risks from abroad could keep him on hold for longer.

And he indicated as recently as last week that he views the factors pushing inflation higher - for example, gas prices and the impact of the harmonized sales tax introduced last year - as temporary.

Indeed, in contrast to the shift in sentiment among currency traders, some of the economists who believed Mr. Carney would continue to stand pat until 2012 stuck to their outlook even after the inflation report.

Derek Burleton, deputy chief economist at Toronto-Dominion Bank, pointed out that inflation expectations are well anchored, because the strong Canadian dollar will probably keep pulling down prices for imported goods and holding back economic growth by making life harder for exporters. In addition, he noted, wage pressures aren't building quickly enough to spark a broader inflationary spiral, and many companies are still skittish about raising prices on finished goods even as they grapple with higher input costs.

"I think it's far too early to push the panic button," Mr. Burleton said. "Consumers are becoming more cautious, and that's going to limit the potential for companies to pass on price increases. Even if growth rebounds in the second half, we're looking at 2-2.5 per cent - hardly an environment that's ripe for passing through higher costs to consumers."

Policy makers will have a better sense of that dynamic in hand as they prepare their July 19 interest rate decision and a new forecast due the following day. The central bank releases its quarterly survey of businesses across the country on July 11, and that will provide the latest snapshot of whether executives are confident enough to raise prices en masse.

But some economists maintain that inflationary pressures will force Mr. Carney's hand soon.

For Stéfane Marion and Matthieu Arseneau of National Bank Financial in Montreal, the fact that core inflation has overshot the central bank's projections for a few months now "suggests that spare capacity in Canada is dwindling quickly" and policy makers will need to acknowledge this somehow in their July forecast.

"The bank may not want to raise rates as soon as July given the still uncertain situation in the euro zone and the U.S. debt-ceiling negotiations," the economists wrote in a note to clients, "but if things begin to normalize, it will be difficult not to do so" at the following decision on Sept. 7.

When things will begin to normalize, and what constitutes "normal" conditions in the first place are questions without clear answers. Mr. Carney has said "some" of the monetary stimulus in the economy will be withdrawn "eventually" if growth continues, but he has also suggested that he doesn't necessarily need to be at a so-called neutral interest rate by mid-2012 in order to keep inflation in check.

Even if May proves to be the "high-water mark" for core inflation, though, as Mr. Burleton predicts, pressure is mounting for Mr. Carney to give a stronger signal that he'll tighten at least once before 2012.

Douglas Porter, deputy chief economist at BMO Nesbitt Burns, noted in a report that the six-month trend for core inflation has actually been higher than 2 per cent - and that's with a loonie above parity for much of this year, suggesting the currency's perceived effect on domestic prices is exaggerated.

"Suffice it to say, the debate on rate hikes in 2011 is alive and well," Mr. Porter said.

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