Unexpected inflation drop won’t hasten Bank of Canada’s rate cut plans, economists say

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The Bank of Canada is still likely to wait until mid-year before delivering its first rate cut, despite January’s downside surprise in inflation, economists say.

Headline inflation came in below expectations with a 2.9% reading in January against expectations of 3.3% and December’s 3.4% pace. It’s the first time the headline CPI reading has fallen below 3% since June 2023 when it dipped to 2.8%.

The slowdown was driven largely by lower energy prices, specifically a 4% annual decline in gas prices, and a cooling of grocery prices, which came in at 3.4% compared to 4.7% in December.

“There is little debate on this one—it’s a much milder reading than expected, especially given the high-side surprise seen in last week’s round of U.S. inflation reports, a nice contrast,” wrote BMO chief economist Douglas Porter.

“Importantly, January can set the tone for inflation,” Porter added, “since firms often take the opportunity to adjust prices for the year in this month—and there was little sign of a big January bump this year.”

The Bank of Canada’s preferred measures of core inflation, which strip out food and energy prices, also trended downward. CPI-median eased to 3.3% (from 3.5% in December), while CPI-trim fell to 3.4% from 3.7%.

Shelter costs keeping upward pressure on inflation

Unsurprisingly, shelter costs continue to exert upward pressure on inflation, and actually rose in the month to an annualized +6.2% from +6% in December.

An ongoing supply-demand imbalance is also keeping upward pressure on rent inflation, which picked up to 7.8% from 7.5% in December. As we reported last week, average asking rents were up another 0.8% month-over-month to a record $2,200.

The Bank of Canada’s own interest rate hikes are also continuing to work their way through the economy, with the mortgage interest cost component of the CPI basket up 27.4% year-over-year.

“Shelter inflation has become the biggest hurdle preventing the Bank from cutting interest rates,” TD economist Leslie Preston wrote in a research note.

“Shelter inflation will remain sticky as higher interest rates feed through to mortgage interest costs with a lag, and undersupply of housing continues to boost rent prices,” RBC economists Nathan Janzen and Abbey Xu wrote. However, “the most likely path for inflation going forward is still lower with per-capita GDP and consumer spending continuing to decline,” they added.

What the inflation figures mean for Bank of Canada rate cuts

Most economists say the first Bank of Canada rate cut is still on track for its June 5 meeting, believing the central bank will want to see additional signs of easing inflation pressures.

“While no doubt welcome news, the Bank of Canada will likely remain cautious in the face of still-strong wage gains, firm services prices, and the reality that core inflation is still holding above 3%,” Porter wrote. “But clearly today’s result makes rate cuts much more plausible in coming months.”

RBC’s Xu and Janzen pointed out that stronger-than-expected job gains in January are another factor that will likely keep the Bank on the sidelines for now.

“A strong start to 2024 for labour markets gives the BoC more leeway to wait for firmer signs that inflation is getting back under control before pivoting to interest rate cuts,” they wrote. “As of now, our base case assumes the BoC starts to lower interest rates around mid-year.”

Earlier this month, Bank of Canada Governor Tiff Macklem told a parliamentary finance committee that the central bank doesn’t need to wait until inflation is all the way back to its neutral target of 2% before it starts cutting rates.

However, he added that “you don’t want to lower them until you’re convinced…that you’re really on a path to get there, and that’s really where we are right now.”

Following today’s inflation release, bond markets raised their rate-cuts odds slightly. They are currently pricing in a 29% chance of a quarter-point cut in March, and an 11% chance of 50 bps worth of easing by June.

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