Has the Bank of Canada conquered inflation? It's complicated

Whether you are a homeowner facing the cost of renewing a mortgage or a business financial officerlooking to renegotiate an essential loan, rising interest rates are causing a world of hurt for Canadian borrowers.

The latest data out Wednesday showed inflation had plunged to a two-year low of 3.4 per cent, a trifling few decimal points away from the Bank of Canada'sone-to-three per cent target range. So why doesn't it just stop the pain?

"The bigger question is: Does the Bank of Canada believe that it can bring inflation back to two per centwithout creating recessionand [it] has to ask itself what is the cost of further rate hikes?" Frances Donald, global chief economist atManulifeInvestment Management, said in a CBCNews interview shortly afterthe release of the consumer price index (CPI) data.

Central bank creates inflation

A lot of smart people in the financial sector seem to think a recession is coming. And yeta lot also think thatbefore that,central bankers here, in the United States and overseas are going to raise interest rates some more.

The fact is, fighting inflation is complicated and politicallydivisive.And for central banks, it becomeseven more complicated and politically divisive as inflation gets closer to their target, because rate hikes hurt more for less obvious reward.

As Donald pointsout, higher interest rates won't end Russia's war onUkraine or fix a devastating disease in the California orange cropdriving up prices or keeping them high.

There are few inflation riddles harder to solve than the fact that the Bank of Canada'sowninterest rate hikesare actually driving inflation higher, with the mortgage cost component of the CPI climbing 30 per cent in the latest Statistics Canada data.

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"If you take out mortgage interest rate costs, then inflation is running much closer to 2.5per cent," Donald said.

The problem, said Stephen Tapp, chief economist with the Canadian Chamber of Commerce, is that there are plenty of signs that inflation has not gone away. And it's more complicated than looking at the headline number.

Worried about getting stuck

I spoke to Tapp because he helped explain the concept of core inflation back in 2022, and why it showed thatthe new generalizedrise in prices at the time was worrying to Tiff Macklem, governor of Canada's central bank.

Back then, headline inflation led the way, driven by volatile segments like oil and gas following the Russian invasion.

This time, the fall in gas pricesmakes it look as thoughinflation is tumbling. Butoverall price pressures demonstrated by core inflation are actually higher than the headline inflation number and the Bank of Canada is worried they could become stuck.

Survey data from the Chamber of Commerceshows that businesses expect their costs, including the cost of labour which is currently rising at about fiveper cent will mean they'll have to charge more over the coming three months.

"They suggest businesses still face broad-based cost pressures and corporate pricing behaviour that the central bank's been looking to normalize is far from normal at his point," Tappsaid.

Businesses, he said,expect inflation to remain above the bank's target, and they want to be prepared.

Companies plan more price increases

"Yes, inflation's slowing, but we still have almost 30 per cent of companies that expect to raise prices," Tappsaid. "It looks like we'll get stuck around the three, 3.5, fourper cent range."

The other complication in reading the inflation data is called the "base-year effect," whichdistorts the data by making oil prices lookincredibly cheap and mortgage costs incredibly expensive. He said that while both are mathematically real, they can be deceptive.

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Canadian consumers are hoping for some relief as inflation drops to 3.4 per cent, the lowest it's been since 2021, but food and mortgage costs continue to soar, which could mean another interest rate hike is possible.

Following Russia'sinvasion of neighbouring Ukraine in February 2022, the global price of crude oilskyrocketed, driving gasoline prices above $2a litre across Canada. Gas is still expensive in historic terms, but compared withlast year's highs, it is much lower bringing down the annualheadline inflation figure. In a few months, oneyear after oil prices slumped, that effect will disappear.

Tapp said the same thing applies to mortgages but in reverse, as rates rose by fourpercentage points from a very low level. And as with oil, he said, thatshocking 30 per cent rise in mortgage rates will soon wash out of the data.

"If you fast-forward this movie, the Bank of Canada's not going raise interest rates another four per cent I certainly hope not," he said. "In the year-over-year comparison, you could have interest costs essentially flat next year."

But he said that is of little reassurance to someone trying to get or renew a mortgage now, even if central banks must look past short-term distortions in any single sector.

Rate hike still baked in?

While economists have said that a quarter-point hike in interest rates at theBank of Canada's July 12meeting are "baked in," both Tapp and Manulife's Donald say there are things that could dissuade the central bank from raising rates.

On Friday, Canada's economic growth figures could show the economy has begun to slow. A significanteconomic slowdown could convince the central bank it is done raising rates for now.

Also on Friday, the Bank of Canada releases its own surveys ofbusiness and consumer expectations. A week later, employment data will offer hints as to whether a tight job market and rising wages havebegun to cool.

"We're not there yet, and we're unlikely to get there if you look at the overall package of wage pressures,pretty high and growing inflation expectations still above target, and business pricing behaviour," Tappsaid.

That pricing behaviour is part of the psychological inflationary spiral the Bank of Canada is strugglingto break, onewhere everybody thinks they are not the cause of inflation but only responding to rising costs elsewhere in the economy.

"Most companies tell us their profits are going to be shrinking, that margins will be going down," Tappsaid. "That's mainly because prices will be going up, but costs will be going up faster."

For the Bank of Canada, he said, it's just too early to walk away and say "mission accomplished."