Canadian Inflation and Interest Rate Forecast

The Consumer Price Index (CPI)

In Canada, inflation is measured by the Consumer Price Index (CPI), which tracks the price changes of a basket of goods and services commonly purchased by households. The inflation rate is expressed as an annual percentage change in the CPI.

For instance, if the CPI increases by 2% over a year, it indicates a 2% inflation rate. This means that, on average, the cost of the basket of goods and services has risen by 2%.

The CPI basket includes eight categories of goods and services: Food, Shelter, Household operations, Clothing, Transportation, Health, Recreation, and Alcoholic beverages.

Relationship between Inflation and the Bank of Canada's Interest Rate

The Bank of Canada is responsible for monetary policy in Canada, and it uses the overnight interest rate as its primary tool to achieve its inflation target. The Bank of Canada's inflation target range is typically set at 2% to maintain price stability and support economic growth.

The Bank of Canada might increase the overnight interest rate if inflation rises above this target. This increase makes borrowing more expensive, reducing consumer spending and business investment, which, in turn, helps cool down the economy and moderates inflation.

Conversely, if inflation is below the target, the Bank of Canada might lower interest rates to stimulate economic activity. Lower interest rates make borrowing cheaper, encouraging consumers and businesses to spend and invest, which can help boost inflation.

The story so far

A spike to 8% in inflation last year prompted the Bank of Canada to initiate several interest rate hikes starting in March last year- the ten rate hikes culminated in interest rates rising to a 22-year high of 5.0%.

On October 25th, 2023, the Bank of Canada declared its decision to maintain the interest rate at 5%.

The Central Bank has one upcoming interest rate decision left in 2023, the coming December 6th.

Inflation and current Consumer price index

According to Statistics Canada, the Consumer Price Index or inflation rate was at 3.1% year-over-year increase in October. This was lower than the 3.8% gain in September but above the Central Bank's 2% inflation target.

This deceleration was mainly due to a decrease in gasoline prices (-7.8%). Excluding gasoline, the CPI rose 3.6% in October.

Prices for goods generally trended lower while prices for services increased at a faster pace (+4.6%), driven by higher costs for travel tours, rent, property taxes, and other special charges.

Key factors driving the year-over-year CPI increase were mortgage interest cost, store-bought food, and rent. In October, the CPI rose 0.1% from the previous month, influenced by increased prices for annual items like travel tours and property taxes. However, when seasonally adjusted, the CPI decreased by 0.1% on a monthly basis.

Forecast for Canada's inflation and Interest rate

BoC Governor Tiff Macklem has hinted that interest rates may have peaked at the current 5%. His exact quotes when speaking to the Saint John Region Chamber of Commerce in New Brunswick were:

"This tightening of monetary policy is working, and interest rates may now be restrictive enough to get us back to price stability,"

He added: "We expect the economy to remain weak for the next few quarters. The excess demand in the economy that made it too easy to raise prices is now gone."

His comments correspond with predictions from analysts of interest rate cuts by the middle of next year.

Forecast from the Bank of Canada's third-quarter survey of market participants

The survey conducted between September 20 and 28 included senior economists and strategists. The median forecast from the survey predicted the Bank of Canada would hold the benchmark steady at 5.0% until April 2024, at which point the Bank will initiate its first rate cut of 25 basis points.

The participants also expected the benchmark rate to drop to 4.0% by the end of 2024.

Why the Bank of Canada is surprisingly vague about future cuts or hikes

When speaking to CBC, Frances Donald, chief economist at Manulife Investment Management, who believes that the Central Bank is done hiking, hinted at why they would be reluctant to break the news to the public.

"If people believe there's rate cuts, maybe they'll start to go out and inflate housing again and spend and then we're kind of back in this inflationary mess," she said.

"So just like a parent that's trying to control their child's behaviour, I think we're probably going to be told one thing, but there might be something else happening behind the scenes."

Perch forecast

Alex Leduc, Principal Mortgage Broker and CEO of Perch predicted no change in December.

A major factor could be the slowing inflation indicated by October's CPI, which could keep further bank hikes at bay.

According to Perch, there is less anticipation of the rate decreasing in the long term. Instead, there is an expectation for prolonged higher inflation and a need for the Bank of Canada to commit to a higher policy rate.

They also predict that Canadian mortgages to be renewed in 2025/2026 will have to plan for higher-than-expected renewal rates.

What affects the Bank of Canada's interest rate forecast

Their forecasts were based on available stats, including:

• October's 3.1% year-over-year rise in CPI.
• Job numbers for September exceeding expectations, with a gain of 64,000 jobs, while the unemployment rate remained at 5.5% for a third consecutive month.
• The average wage growth increased to 5.0% in September, compared to 4.9% in August, indicating inflationary pressures.
• Canadian 5-year bond yields which are at around 4.2% due to factors like job market strength, war concerns, market uncertainty, and speculation about US Fed rate hikes.

The Exchange rates

Unlike inflation, the Bank of Canada doesn't actively try to set the Canadian dollar's exchange rate. The Canadian dollar floats in the market where its value is determined by demand for Canadian goods and services, along with other factors like:

• Commodity prices
• Bank of Canada's interest rates
• Employment rate and job creation
• Budget deficit and debt levels
• International policies and Canadian-US relations.

Intervention is only done in rare cases if the value of the CAD falls or rises too quickly.

Will the USD/CAD Exchange rate affect inflation?

There were initial fears that the weaker Canadian dollar (against the USD) would increase import prices and reinflate the market.

However, according to an RBC Economics and Thought Leadership article, a weak CAD doesn't derail inflation trends in an increasingly service-dominated economy. The takeaway is that demand, not currency, decides where prices go.

Canada also imports more from countries outside the US, making fluctuations between the USD and CAD less relevant to prices than before. An example is the increase in Chinese imports and the relatively strong CAD against the yuan.

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