FLCA - Why A BOC Rate Hike Is Still On The Table Despite An Inflation Rate Drop In May

2023-06-28 22:06:00 ET

Summary

• Canada's inflation rate slows, but likely not enough for the BOC.
• Why the Bank of Canada is determined to hit its 2% target.
• Canadian inflation may have fallen in May but interest on mortgage costs surged last month.

Canada’s annual inflation rate slowed to 3.4% in May, its lowest level since June 2021. Robert Both, Macro Strategist with TD Securities, speaks with Greg Bonnell about why the Bank of Canada is still likely to hike rates one more time this year even as inflation shows signs of cooling.

Greg Bonnell: Headline inflation in Canada cooled significantly in May. A big drop in gasoline prices compared to last year. But as we dig into the details of the report, will it be enough for the Bank of Canada to go back on hold? Joining us now to discuss, Robert Both, macro strategist with TD Securities. Robert, great to have you on as always. Great on a day like this.This is the big question. We have another rate decision just in a couple of weeks' time. What does the Bank of Canada do with an inflation report like this?

Robert Both: Well, thank you for inviting me back on, Greg. As you mentioned, inflation did move quite a bit lower in May. It fell a full percentage point to 3.4%. So for a lot of us at the surface level, that is very welcome news for especially anyone who's had a little more difficult time with the rising cost of living over the last couple of years.

If you do spend a little more time looking at the data, the drop in year-over-year inflation shouldn't have come as too much of a surprise. As you mentioned, gasoline prices were a key driver of that decline from last year. But if you look at the change in gas prices between April and May, they didn't move too much. And prices overall rose by 0.4% month over month.

Now, that was roughly in line with where the market expected it, so it's not going to be too much of a shock for the Bank of Canada relative to their assumptions heading into this morning's report. But inflation is still much too high for comfort, especially when you look at those core inflation measures.

So there are two measures that the Bank of Canada looks most closely at. Those are the trimmed mean and the weighted median. Those fell by a pretty large 0.4 percentage points, from 4.25% to 3.85%, but they're still rising by about 0.2% month over month. So we're starting to move in the right direction.

But if you look at the three-month annualized rates of core inflation as well, they're still around 3.7%. Again, it's too high to be comfortable at these levels. The Bank of Canada wants to see those get closer to 2%. And so long as prices are rising by 0.4% month over month, we're going to need to see more progress before we can really feel comfortable that there are no more rate hikes to come down the pipeline.

Greg Bonnell: What I found it really curious in this report, you're right, pretty well telegraphed. I mean, you didn't have to be a genius to know that you're paying less at the gas pump compared to the same time last year when we had a barrel of crude almost at $120. But the mortgage interest cost, which obviously you don't have to be a genius to figure out. They're higher this year than they were last year at this time because of the rate hikes.

But if you strip those out, inflation was roughly around 2.5%. To me, that struck me as a curiosity because this is something the Bank of Canada has done. It has raised rates. It has raised mortgage interest rates. Do they take that into account at all? Are they happy to see a pullback in housing?

Robert Both: Well, that's why the Bank of Canada likes to focus more on those core inflation measures that do remove some of the more volatile components, such as mortgage interest costs. This is not necessarily anything new over the last month, but this has been something over the last six months, that mortgage interest costs have been contributing more and more to the year-over-year increase in inflation.

However, there are other components of the CPI basket that have also traditionally done well when the bank is cutting rates, things like homeowner replacement costs, or anything else that's directly tied to house prices. Those have always been looked at together with the rest of the index. So we wouldn't expect the Bank of Canada to begin looking explicitly past those mortgage interest costs.

They do have their core measures for a bit of an operational guide, and they'll put a little more weight on those when there is one component that's driving a lot of the volatility. But those core inflation measures are still running at a rate that's not quite consistent with a return to that 2% target. So we do need to see some more evidence of demand slowing and the economy coming back into balance to get all the way back to 2%.

Greg Bonnell: In the early innings when inflation started to gather steam when we were told it was transitory, which seems like a million years ago, it was largely about the goods because we had some real problems in terms of supply chains coming out of the pandemic. Services is what a lot of people have been talking about lately.

I think we can show the audience the difference between now between core goods and services as measures of what's happening in inflation right now. Is this something that's troubling for the bank, the fact that services are sort of-- they're coming off but not all that dramatically?

Robert Both: I would say it's a little troubling for the bank. It's something they've been watching for a few months now. And we do expect that gap to continue to widen over the next few months because service prices do tend to be a little more sticky than goods prices. And they're especially a little closer tied to labor market outcomes.

So until we see the labor market move a little closer to balance, until wage growth is running well below 5%, I think we can expect some of that persistence in services to continue. And especially in the shelter component as well, which is a little less tied to those labor market outcomes, we would expect that to remain a source of upward pressure on inflation over the next year, year and a half.

Greg Bonnell: I mean, the labor reports have always been important, but I felt like once we got into this battle against inflation, the jobs report sort of got pushed to the side. We still paid attention, but it was the inflation report that was stealing all the headlines. Now that we're at this sort of stage in the inflation fight, does that labor market report become all the more important to us?

Robert Both: I think we'll be looking at the labor market data a little more closely for kind of insight into how we expect services inflation to develop. I think inflation is still, first and foremost, what the Bank of Canada is looking at. It is their sole mandate in Canada.

They are determined to get back to 2%, and the labor market is a little bit secondary to that. Obviously, the growth data is also very important. We need to see growth slow from those above-trend rates we've seen over the last year or so. We saw quite a strong growth in the first quarter of this year, and that also has us a little more concerned that some of these inflation pressures could take a little bit longer to fizzle out.

Greg Bonnell: So we do have a Bank of Canada rate decision on July 12. It's only a couple of weeks away. Coming out of that one, would you expect perhaps then after that they could sort of go back to the sidelines, assess further where we're headed, or are there signs here that maybe they need to keep going?

Robert Both: Right. I guess we need to get through July 1, but that was one of the questions we had going into today's CPI report was a July rate hike looks extremely likely. I think it would take a significant disappointment on the inflation data to move the bank away from a hike in July. And we didn't get that.

There's not too many other major data points that might move the needle between now and July 12. So I do think they are going to raise rates one more time. And then once we get past July, I think it's going to be a bit more of a data-dependent approach going forward.

So there's a lot of economic data before we get to September. And I think you're going to need to see more concrete evidence of that slowdown in economic activity. You're also going to need to see inflation continue to moderate, and especially those core inflation numbers. And we've got three months before we get there. So that's what we'll be watching. But for now, we do look for the rates to peak at 5%.

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