As the Bank of Canada prepares to make its first interest rate decision of the year on Wednesday, economists say headwinds in the “last mile” of the inflation fight will serve as a final hurdle before rate cuts can begin.
Inflation has cooled significantly from highs of 8.1 per cent in the summer of 2022, thanks in part to the Bank of Canada’s rapid run-up in its benchmark interest rate. But while the first year of the central bank’s rate tightening cycle saw inflation drop more than five percentage points, the rate of annual price hikes has remained largely steady in the range of three to four per cent over the past half year.
Inflation ticked up to 3.4 per cent in December 2023, according to Statistics Canada, as gas prices fell by less than they did in the same month a year earlier.
While the mild acceleration was expected by forecasters, BMO chief economist Doug Porter flagged a stubbornness in core inflation holding around the mid-three per cent market as “unsettling news” for the Bank of Canada’s efforts to restore annual price pressures to the two per cent target.
“The last mile (or kilometre) of the inflation fight may prove to be the most challenging,” he wrote in a note to clients last week.
James Orlando, director of economics at TD Bank, tells Global News that inflation eased more quickly in the beginning of the tightening cycle because of the reasons price pressures shot up in the first place: supply chain bottlenecks.
The current inflationary period was primarily fuelled at first by global supply chains failing to meet a surge of demand in the pandemic recovery, intensified by Russia’s invasion of Ukraine driving up prices on oil and food. Orlando explains that as these pressures unwound, inflation dropped with it.
“The low-hanging fruit on getting inflation back down has been picked,” Orlando says.
But easing supply chains could only take the inflation fight so far, as they primarily influence goods prices. What’s driving inflation higher today, Orlando says, are demands for services as well as for shelter amid surging rent and mortgage costs.
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But taming shelter inflation, which ran close to six per cent in December, doesn’t have a straightforward fix like remedying supply chains. The pressure in the rental market, for instance, is tied to “years and years of underbuilding” in Canada, Orlando says.
Solutions for a housing deficit take years to resolve, with the rental market unlikely to rebalance even amid efforts at multiple levels of government to quickly add supply, he explains.
“You can’t just bring more housing supply rapidly onto the market to fix that balance like you could with, say, semiconductor chips,” Orlando says.
“That’s why people say that last mile on inflation is going to be a lot harder to bring down, because that’s just a slow-moving train that we’re dealing with.”
The Bank of Canada is widely expected to hold its benchmark interest rate on Wednesday.
Orlando explains that the decision for the Bank of Canada now is to gauge not whether it has sufficiently tightened monetary policy, but rather when it needs to shift to kickstarting the economy rather than cooling it.
To make that judgment, he says the central bank will have to pay close attention to the Canadian consumer.
Consumer spending in Canada has been largely flat over the past year, Orlando explains, but those trends are expected to weaken even further with more households due for mortgage renewals in 2024.
TD mortgage and credit card data since 2021 show that households with mortgage renewals in 2023 were forced to rein in their expenses to accommodate higher monthly payments, but those with terms expiring in 2024 largely haven’t made changes to their spending yet.
Orlando says that with these renewals on the books, the Bank of Canada can be fairly confident that consumer spending — and by extension, the economy and inflation — are set to slow further in the year ahead.
“All the factors are in place that should lead consumer spending in Canada to still remain weak in 2024,” he says. “And if I’m the Bank of Canada, I’m thinking, ‘OK, that means that we’ve probably done enough on interest rates.’’
RBC economists Nathan Janzen and Claire Fan said in a note to clients last week that inflation and still-high wage growth has been “too sticky” to allow the Bank of Canada to pursue early interest rate cuts. They said they expect the Bank of Canada to push back against the idea that a shift to rate cuts is coming soon.
Porter said in his note that persistent wage pressures and signs in late 2023 that the housing market was stirring would have the central bank “doggedly maintain a cautious stance” about the path for rates in its communications this week.
Both RBC and BMO expect interest rate cuts to begin sometime in mid-2024, but TD Bank is among those forecasters expecting easing to begin in the spring.
That’s not a foregone conclusion, Orlando notes, particularly given risks in the same global supply chains that underpinned the initial run-up in inflation. Houthi attacks on ships in the Red Sea have forced a rerouting of trade routes and driven up freight costs in recent weeks, for example.
Fresh geopolitical tensions like these risk turning the tailwinds from unwinding supply chain kinks into headwinds, Orlando says, which if they materialize into significant price pressures, would mean “all bets are off” for where inflation lands in 2024.
However, he also notes that the risks to the downside for inflation if the Canadian economy slows more sharply likely outweigh the upside risks of another supply chain shock for the Bank of Canada at this juncture.
If the Canadian economy happens to accelerate, for example with a strong spring housing market, and the job market remains resilient, Orlando says that will push back the Bank of Canada’s schedule for rate cuts. Conversely, if there’s a sharper slowdown, expect that timeline to move up.
Orlando says that while the labour market showed plenty of signs of cooling in 2024, that slowdown might start to bring about net job losses in the months ahead. Like mortgage renewals, a rising trend of layoffs would have lots of influence over Canadian consumers if they see their incomes take a significant hit.
“As the Canadian consumer goes, so goes the Canadian economy,” Orlando says.
