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The Globe and Mail

Canada inflation up, interest rates next? Not so fast

As any good zombie will tell you, being undead is not quite the same as being alive. The same is true for the remarkable rise from the grave of Canada's inflation rate.

Canadian consumer price index (CPI) inflation hit the magical 2 per cent year-over-year rate in April, its highest rate in two years, and up sharply from 1.5 per cent in March. It's the culmination of a six-month surge that has lifted inflation from a thin 0.7 per cent last October – a pace so disturbingly low that people were talking about Canada's looming deflation threat and calling on the Bank of Canada to slash interest rates.

I say "magical" because 2 per cent is, indeed, the Bank of Canada's target CPI rate – the inflation sweet spot that it aims to achieve when crafting its interest-rate policy. Indeed, reaching 2 per cent, coupled with the evident upward trajectory of inflation, would generally be considered a strong signal that the central bank would want to increase interest rates in the not-too-distant future, to dampen the apparent acceleration in inflationary pressures. It would seem to imply a re-think of the consensus expectation that the Bank of Canada won't raise rates until the second half of 2015, at the earliest.

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But not all 2 per cents are created equal. This latest inflationary surge, on closer inspection, does not show the hallmarks of a broad-based upturn fuelled by widespread economic acceleration, the kind of traits that would make it look sustainable and thus of concern to central bank policy makers. Rather, it's fuelled by, well, fuel – and not a whole lot else.

Energy costs – gasoline, natural gas, electricity – are up 8.4 per cent over the past 12 months, and are up 9 per cent since inflation bottomed in October. If you take energy out of the equation, Canada's inflation rate is a mild 1.4 per cent year-over-year. Indeed, the Bank of Canada's core inflation rate – which excludes the most volatile components, primarily energy and food – was also 1.4 per cent.

This core rate is the central bank's primary focus, because it is much more indicative of the kind of broader inflationary pressures that prevail in a healthy, expanding economy where spare capacity is evaporating. And despite the fact that all 12 of the major components of Canadian CPI have risen in the past 12 months (and most components were up in April), the lack of similar momentum in the core measure suggests that the energy contribution to many of these components has been the big driver. The combination of rising energy prices and a weaker Canadian dollar have lit a fire under Canada's inflation rate, but Bank of Canada Governor Stephen Poloz has been quite clear that he expects these effects to be transitory.

There's little reason to think Mr. Poloz will be swayed by Friday's big inflation number. He'll want to see much more in terms of underlying evidence of economic acceleration before he'll reconsider his outlook. Thursday's disappointing retail sales data (down 0.1 per cent in March) certainly contribute to doubts that the broader economy has much momentum to sustain the inflation gains.

Nevertheless, the Bank of Canada will have to address the unexpectedly strong inflation rebound when it next issues a rate-policy statement, on June 4. The bank hadn't expected total CPI inflation to return to 2 per cent until the end of this year, so even with the temporary factors, inflation is getting ahead of the bank's outlook. Mr. Poloz will need to enunciate the bank's interpretation of the inflation numbers, and set the markets straight on where they fit into the bank's growth and interest rate expectations.

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