Macklem’s Op-Ed (emphasis is mine)
National Post Comment, August 16, 2022

Inflation in Canada has come down a little, but it remains far too high. After rising rapidly to reach 8.1 per cent in June, inflation as measured by the consumer price index (CPI) was 7.6 per cent in July.

The good news is that it looks like inflation may have peaked. The price of gasoline, which has contributed about one-fifth of overall inflation in recent months, declined from an average of $2.07 a litre in June to $1.88 a litre in July. And we know gas prices at the pump have fallen further so far in August. Prices of some key agricultural commodities, like wheat, have also eased, and global shipping costs have fallen from exceptionally high levels. If these trends persist, inflation will continue to ease.

The bad news is that inflation will likely remain too high for some time. Many of the global factors that have pushed up inflation won’t go away quickly enough — supply chain disruptions continue, geopolitical tensions are high, and commodity prices remain volatile. And here at home, our economy has been running too hot. As Canadians finally enjoy a fully reopened economy, they want to buy more goods and services than our economy can produce. Businesses are having trouble keeping up with demand, and that’s leading to delays and higher prices. The result is broad-based inflation. Even if inflation came down a little in July, prices for more than half of the goods and services that make up the CPI basket are rising faster than five per cent.

As the central bank, it’s our job to control inflation and that means we need to cool things down. That’s why we have been raising interest rates since March. In July, we took the unusual step of raising the policy interest rate by a full percentage point, to 2.5 per cent. Increasing our policy rate raises borrowing costs across the economy — for things like personal loans, car loans, and mortgages. And when we increase the cost of borrowing, consumers tend to borrow and spend less and save more. We need to slow down spending to allow supply time to catch up with demand and take the steam out of inflation.

One area of the economy where it is easy to see how this works is the housing market. With higher mortgage costs, housing activity has slowed quickly after unsustainable growth during the pandemic, and housing prices are moderating. As housing slows, peoples’ spending on housing-related goods and services, such as renovations and appliances and furniture, should also slow.

To tame inflation, we need to bring overall demand in the economy into better balance with supply. Our goal is to cool the economy enough to get inflation back to the two per cent target. We don’t want to choke off demand — we want to slow its growth. That’s what we call a soft landing. By acting forcefully in raising interest rates now, we are trying to avoid the need for even higher interest rates and a sharper slowing down the road.

I know some Canadians are asking, “Why are you raising the cost of borrowing when the cost of everything is already too high?”

We recognize that for many Canadians higher interest rates will add to the difficulties they are already facing with high inflation. But it’s by raising borrowing costs in the short term that we will bring inflation down for the long term. This will ultimately be better for everyone because high inflation hurts us all. It eats away at our purchasing power and makes it difficult to plan our spending and saving decisions. It feels unfair and that erodes confidence in our economy.

The best way to protect people from high inflation is to eliminate it. That’s our job, and we are determined to do it. Tuesday’s inflation number offers a bit of relief, but unfortunately, it will take some time before inflation is back to normal. We know our job is not done yet — it won’t be done until inflation gets back to the two per cent target.

Tiff Macklem is governor of the Bank of Canada

Bottom Line

I published Macklem’s statement in its entirety to do it justice. You can decide whether you think the overnight rate will go up by 50 vs 75 bps on September 7th, but undoubtedly it will go up. It is also clear that the Bank will not cut the policy rate until inflation is at the 2% target. So don’t assume that variable mortgage rates will decline quickly in response to a slowdown in the economy. The Bank’s emphasis on the housing slowdown being an essential precursor to the reduction in overall economic activity portends an extended period of credit stringency.

This is a sea change in the economy. This is the end of a forty-year bull market in bonds triggered by the disinflationary forces of globalization, cheap emerging market labour and rapid technological advance. It is also the end of very cheap credit. Household balance sheets will feel the pinch. Recent home borrowers who benefited from the record-low mortgage rates for the two years beginning in March 2020 will increasingly feel the constraint of higher borrowing costs on their discretionary spending. Ultimately, this will return inflation to its 2% target, but it will take a while.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres

Gasoline Prices Dipped, But No Time To Celebrate

While we are all grateful that gasoline prices declined from record highs in July, today’s release of the July inflation data shows that the underlying inflation momentum remains too strong for comfort. Governor Macklem will likely continue to hike the policy rate aggressively when they next announce their decision on September 7th. Judging from the swaps market, traders are betting evenly on a 50 bps vs. 75 bps increase next month.

The Consumer Price Index (CPI) rose 7.6% in July from a year earlier, compared to 8.1% in June. The dip reflected the largest drop in gasoline prices since the pandemic’s beginning.

On a monthly basis, however, inflation increased 0.1% from the June reading, the seventh consecutive rise. Excluding gasoline, prices rose 6.6% y/y last month, following a 6.5% increase in June, as upward pressure on prices remained broadly based.
Consumers paid 9.2% less for gasoline in July compared with the previous month, the largest monthly decline since April 2020. Ongoing concerns related to a slowing global economy, as well as increased COVID-19 pandemic public health restrictions in China and slowing demand for gasoline in the United States, led to lower worldwide demand for crude oil, putting downward pressure on prices at the pump.

On a monthly basis, gasoline prices fell the most in Ontario (-12.2%), where the provincial government temporarily lowered the gasoline tax.

Prices for food purchased from stores increased more on a year-over-year basis in July (+9.9%) than in June (+9.4%). Prices for bakery products (+13.6%) continued to rise faster as wheat prices remained elevated. Higher input costs and global supply uncertainty related to the Russian invasion of Ukraine continued to put upward pressure on global wheat prices amid an already constrained supply.

Other food items also exhibited faster price growth, including non-alcoholic beverages (+9.5%), sugar and confectionery (+9.7%), preserved fruit and fruit preparations (+10.4%), eggs (+15.8%), fresh fruit (+11.7%), and coffee and tea (+13.8%).

On a year-over-year basis, the mortgage interest cost index (+1.7%) increased for the first time since September 2020 amid elevated bond yields and a higher interest rate environment.

Year over year, growth in other owned accommodation expenses (+9.7%) and homeowners’ replacement cost (+9.1%) slowed, reflecting current trends in many regional housing markets across Canada.

In the context of higher mortgage rates, which could lead to additional rental demand, rent increased 4.9% in July compared with the same month in 2021, following a 4.3% increase in June. Faster price growth in the rent index was largely driven by an acceleration in Ontario (+6.4%) and Alberta (+3.4%).

Bottom Line

With some luck, price pressures might be peaking. The chart above shows the Bank of Canada’s most recent forecast for inflation. The Bank of Canada estimated inflation would average about 8% through the third quarter of 2022 before slowing. Now, the estimate could be revised a bit lower this time. That is why roughly half of the market participants expect a 50-bps rate hike next month, revised down from the 75-bps figure widely expected a month ago. Either way, the prime rate is rising more rapidly than the five-year government of Canada bond yield, making fixed mortgage rates relatively more attractive than variable rates tied to prime. Regardless of which path the Bank takes at the next meeting, the Bank will stay the course for some time.

Central banks cannot return to easy money quickly without risking another burst of inflation. Even with the Canadian economy slowing sharply in the second half of this year, labour markets remain very tight, and the central Bank is behind the curve. With hindsight, we know they kept rates too low for too long, triggering excess demand, particularly in the red-hot housing sector. Watching that unwind, especially in the country’s most expensive and frothy housing markets, will be the Bank’s most prudent option.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres

Finally, Some Good News on the Inflation Front

It was widely expected that US consumer price inflation would decelerate in July, reflecting the decline in energy prices that peaked in early June. The US CPI was unchanged last month following its 1.3% spike in June. This reduced the year-over-year inflation rate to 8.5% from a four-decade high of 9.1%. Oil prices have fallen to roughly US$90.00 a barrel, returning it to the level posted before the Russian invasion of Ukraine. This has taken gasoline prices down sharply, a decline that continued thus far in August. Key commodity prices have fallen sharply, shown in the chart below, although the recent decline in the agriculture spot index has not shown up yet on grocery store shelves. US food costs jumped 1.1% in July, taking the yearly rate to 10.9%, its highest level since 1979.

The biggest surprise was the decline in core inflation, which excludes food and energy prices. The shelter index continued to rise but did post a smaller increase than the prior month, increasing 0.5 percent in July compared to 0.6 percent in June. The rent index rose 0.7 percent in July, and the owners’ equivalent rent index rose 0.6 percent.

Travel-related prices declined last month. The index for airline fares fell sharply in July, decreasing 7.8%. Hotel prices continued to drop, falling 2.7% on the heels of a similar decrease in June. Rental car prices fell as well from historical highs earlier this cycle.

Bottom Line

The expectation is that the softening in inflation will give the Fed some breathing room. Fed officials have said they want to see months of evidence that prices are cooling, especially in the core gauge. They’ll have another round of monthly CPI and jobs reports before their next policy meeting on Sept. 20-21.

Treasury yields slid across the curve on the news this morning while the S&P 500 was higher and the US dollar plunged. Traders now see a 50-basis-point increase next month as more likely than 75. Next Tuesday, August 16, the July CPI will be released in Canada. If the data show a dip in Canadian inflation, as I expect, that could open the door for a 50 bps rise (rather than 75 bps) in the Bank of Canada rate when they meet again on September 7. That is particularly important because, with one more policy rate hike, we are on the precipice of hitting trigger points for fixed payment variable rate mortgages booked since March 2020, when the prime rate was only 2.45%. The lower the rate hike, the fewer the number of mortgages falling into that category.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres