Series: Macro
Tags: inflation, interest rates, Bank of Canada
Statistics Canada released inflation data on October 19, 2022 showing that CPI inflation was at 6.9% in September. These data shifted expectations regarding what the Bank of Canada (BoC) would do the next week, with the consensus shifting from a 0.50% to a 0.75% raise. On October 26, the BoC announced a 0.50% increase of the overnight interest rate (OIR) target.
I suspect that the shift in expectations was due to many going over the inflation data too quickly. Let’s have a look at them. We will see that we must look beyond annual inflation and that we can expect inflation to stay high for a while.
The BoC targets a 2% annual inflation rate, ±1%. Because that goal is set over annual data, it is easy to ignore monthly inflation. Figure 1 shows monthly inflation from Statistics Canada tables 18-10-0004 and 18-10-0256 for selected product groups, including two in which eight of the most volatile components as defined by the BoC are removed. The latest annual inflation numbers - for September 2022 - summarize monthly prices growth between September 2021 and September 2022.
Annual inflation is a 12-month rolling window. When looking at the change in the annual inflation rate from one month to the next, there is 11 months of data that does not change. To understand, let me compare the annual inflation rates for August and September 2022. The month-over-month (MoM) inflation rate for September 2021 is included in the calculation of the August 2022 annual inflation rate but it gets replaced by the September 2022 data point in the calculation of the September 2022 annual inflation rate. As an example, in figure 1, consider the All-items category. The annual inflation rate for that category declined from 7.0% in August to 6.9% in September as the MoM inflation rate in September 2021 of 0.2% was replaced by a lower 0.1% MoM in September 2022.
Because annual inflation summarizes prices changes over 12 months, it is not too surprising that it moves little month to month. Figure 1 shows that most of the annual inflation we currently observe was created between January and July. It’s when we will go through these months in 2023 that we will really see the annual inflation rate decline. The exception is food for which prices have increased more constantly and thus it will take more time before we see annual inflation for food declining.
What can we expect for the October 2022 annual inflation? Figure 1 shows that MoM inflation rates were strong in October 2021. The MoM inflation rates for October 2022 are likely going to be lower, even though gas prices have climbed recently. For that reason, we should expect lower annual inflation rates, with the likely exception of food. Note, however, that we could see annual inflation rates increase in November and December (see next section) given that we observed low and even negative monthly inflation rates in November and December 2021.
As mentioned above, the high annual inflation rate we currently observe has been mainly from prices growing between January and July 2022. Given that, how long will it take before we return to the BoC’s 2% target?
Figure 2 shows historical inflation annual rates and their paths under scenarios where prices grow at 0, 1, 2, or 3% rates and a scenario where prices growth gradually decline. Consider as an example the scenario with for a 1% growth rate. Under that scenario, prices grow monthly at a rate of \(0,08\%=100*(1,01^{(1/12)}-1)\) such that a year later, in September 2023, the annual inflation rate is 1%. Likewise for the scenarios with 0, 2, and 3% rates. For the gradual decline scenario, it assumes inflation rates in October 2022 corresponding to their latest annual values and that they decline afterward monthly by 10%.
What do we learn from these scenarios?
Under the most optimistic scenario with no inflation, the inflation rate for All-items is 6% in December. It would be over 8% for Food.
Even with no monthly inflation, it would not be before April 2023 that the inflation rate for All-items to decline to 2%.
Most likely, prices will continue climbing but at a rate slower than we observed in early 2022. This will mean that it will be several months after April 2023 that the inflation rate will approach 2%.
In the scenario where inflation rates slowly decline, inflation will still be around 4% for All-items in September 2023. This scenario illustrates how slowly annual inflation rates would decline if interest rate hikes have a small impact prices growth.
Unless food prices start to decline, we will observe a high inflation rate for Food for at least another year.
The message from the BoC is consistent with the scenarios in Figure 2. Indeed, in its October Monetary Policy Report the BoC projects inflation to return to about 3% in late 2023. It takes time for higher interest rates to work their way through the economy and given that we are looking at annual inflation, it is not surprising that we should expect it to stick for a while.
Consumers and businesses inflation expectations matter for future inflation. Indeed, if consumers and businesses believe there will be inflation, they will behave in ways that create conditions for inflation to happen. The October edition of the Canadian Survey of Consumer Expectations shows that consumers expect inflation at 7.1% 1-year ahead and 5.2% 2-year ahead. The Business Leader’s Pulse survey shows that businesses have lower inflation expectations: 4.7% 1-year ahead and 2.9% 2-year ahead. The BoC must change theses expectations for inflation to decline, a difficult task.
What to expect next? In its October announcement the Bank stated that “the Governing Council expects that the policy interest rate will need to rise further.” Thus, we should expect another OIR hike in the next scheduled announcement on December 7. How much? Given that household and business spendings are softening, I’m expecting a 0.25% increase and likely that will be the last of the series.