The Bank of Canada has little choice but to cut interest rates by June. Here’s the math
Canada’s year-over-year inflation dropped to 2.8 per cent in February from 2.9 per cent the previous month, the second month in a row that annual inflation fell within the Bank of Canada’s target range of one-to-three per cent.
This deceleration appears to have caught most experts by surprise — and for the second time in as many months. Indeed, analysts were expecting annual inflation to climb to 3.1 per cent in February, and the Bank of Canada had projected an average inflation rate of 3.2 per cent in the first quarter. Only a few saw this coming.
As a starter, headline inflation did not fall because the monthly consumer price index came down in February. It did not. Actually, CPI increased 0.3 per cent last month — the highest monthly hike of the last six months, equivalent to an annualized rate of 3.9 per cent.
Therefore, the February decline in year-over-year inflation should not have taken anyone by surprise since it was entirely due to the month-base effect.
Indeed, annual inflation decreased despite the fact that average prices rose 0.3 per cent in February. In other words, year-overyear inflation dropped to 2.8 per cent because prices increased more in the base month — 0.4 per cent in February 2023 — than last month.
Further, for annual inflation to have climbed as expected to 3.1 per cent, the monthly CPI increase should have been 0.6 per cent in February — a rate not recorded since July 2023.
How could anyone have expected such a price hike last month? Many analysts cited the increase in gasoline prices as a justification for this dismal expectation. But gas prices had to increase 11 per cent — instead of the actual four per cent — for the CPI to increase 0.6 per cent in February.
So it appears that the probability of annual inflation to have gone up in February was slim.
From the start, the most likely outcome was for inflation to fall — as it actually did, although not by as much as I was expecting.
Why did I expect headline inflation to fall in February? It was based on a simple assumption — that the February CPI increase would be similar to the average of the last nine months.
Given this assumption, my expected yearly inflation for February was 2.6 per cent — plus or minus 0.1 percentage points to account for unexpected factors. Therefore, I expected February inflation to fall in the 2.5 to 2.7 per cent range.
Of course, that unexpected factor was the rise in the price of gasoline — which, after decreasing for five months in a row, increased four per cent in February. And this rise was responsible for 50 per cent of the CPI increase for the month. Excluding gas, the year-over-year inflation would have been exactly 2.6 per cent last month.
So, what can we expect for headline inflation in March and April? One thing seems almost certain: inflation will continue its downward path due to the month-base effect. Assuming monthly inflation remains around the average of the last nine months — I expect March inflation to fall in the 2.3-to-2.5 per cent range, and April inflation to the 1.7-to-1.9 per cent range.
So, inflation could fall below two per cent as early as next month — or close to the Bank of Canada’s target.
What will be the bank’s reaction be to these scenarios?
In its interest rate announcement on Wednesday, the consensus among analysts is that the bank will leave its policy rate unchanged at five per cent — its highest level since March 2001. This appears almost guaranteed since March inflation data will not yet be available to affect the bank’s rate decision.
Of course, the bank will take credit for the drop in inflation since reaching 8.1 per cent in June 2022. “The good news is that monetary policy is working,” the bank’s senior deputy governor Carolyn Rogers said recently in Halifax. And she made this claim while recognizing that the pandemic — not excess demand nor undue wage hikes — was responsible for “the biggest global inflationary episode in decades.”
But the bank will also argue that more needs to be done.
“We know we need to finish the job,” Rogers added. And “upside risks to inflation remain,” bank governor Tiff Macklem told us once again last month.
The alleged upside risks appear to refer to the pace at which wages are recovering lost ground since the spike in inflation in early 2021. Certainly, the labour market remains tight and, on a year-over-year basis, average wages rose five per cent in February — making it 21 months in a row with annual increases above four per cent.
So, the bank will be happy to oblige market expectations and keep its policy rate unchanged in April. This way, it will save its credibility while giving more time for wage pressures to subside.
And for June, most market analysts predict a 25-basis point reduction — bringing the policy rate down to 4.75 per cent, the same level as in June 2023.
If my expectations are confirmed, the availability of inflation data for March and April will leave the bank with no option but to reduce interest rates in June — despite the fact that labour market tightness and wage pressures will most likely remain.
In any case, the bank will again take credit for the drop in inflation and — despite all its efforts to the contrary — without causing a recession, they may add. But wages will likely continue to rise to recover the loss in purchasing power since 2020, and also to return labour’s income-share to the levels preceding the onset of globalization.
In the end, the good news is that the Bank of Canada appears to be losing its nond-eclared war on workers, and wages will continue to rise without fuelling inflation, while corporate profits may be falling.
This should be an occasion for celebration for most Canadians. It creates a scenario for businesses to undertake productivity-enhancing investment — a win-win outcome for business owners and workers, while expanding the material basis needed for an improvement to our standard of living.