BoC enters “tricky” stage as inflation may rise again

Inflation is likely to go higher again before it goes lower, CIBC’s chief economist says, making a soft landing trickier for the Bank of Canada even as inflation shows signs of slowing.

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CIBC’s Avery Shenfeld attributed the peak inflation a year ago to price shocks from the war in Ukraine and lingering effects of the Covid-19 pandemic rather than an overheated demand side of the economy, and thought a soft landing was possible even then.

The progress since, with inflation falling to 2.8% in June, has shown that “a lot of that inflation could melt away on its own once some of those disruptions were behind us,” he said.

However, while Shenfeld still doesn’t think a recession is necessary in Canada and the U.S. to get inflation back to 2%, central banks have entered a “tricky” stage in their task.

“We’ve seen the biggest benefits from the year-on-year decline in gasoline prices so that’s going to drop out as a big downward pull on the inflation rate, leaving the inflation rate drifting a bit higher,” he said.

That means a stall in economic growth for a couple of quarters and at least a slight rise in the unemployment rate to cool wage inflation and bring down purchasing power will be necessary, he said.

“The tough task for the Bank of Canada is to gauge just how many rate hikes are necessary or what level of interest rate is necessary to get that cooling as opposed to a big recession that we simply don’t need,” he said.

Last month the Bank of Canada raised its overnight interest rate to 5%, releasing new projections that suggest it will take longer to get inflation back to 2%.

However, Shenfeld said the BoC should “have enough doubts at this point” to show patience and monitor the economic data rather than raising rates.

“Our view was that even the last rate hike might have been unnecessary,” he said. While the central bank may hike again in September, especially if the unemployment rate moves lower again, Shenfeld said he thinks the economy will slow enough to make a September hike the last.

“One thing we have to remember is that when we’re getting down to the last few rate hikes, there’s an element of art as well as science,” he said, since the market doesn’t respond exactly the same way to higher rates from one business cycle to the next.

While an extra rate hike or two may not be fatal, Shenfeld said the BoC needs to be careful not to overdo it, as excessive rate increases could have significant impacts down the road when more Canadians renew mortgages.

Many Canadians who secured mortgages at historically low rates in 2020 will face significant increases in their monthly payments when they renew. For that reason, Shenfeld said the challenge for the Bank of Canada is judging when to start easing up on interest rates to prevent further economic slowing once inflation returns to the 2% target.

Fortunately, he said Canada has experienced a more substantial decline in inflation compared to other countries, primarily due to falling gasoline prices and other global price declines. With a lot of inflation tied to mortgage costs, which will subside after rate increases cease — and especially when they start to ease — the damage to the Canadian economy may be less severe than elsewhere, Shenfeld said.

Maddie Johnson

Maddie is a freelance writer and editor who has been reporting for Advisor.ca since 2019.