Economists: Essential costs offer idea of sustained inflation decline in Canada

Economists have said that the cost of essentials, including food and housing, can provide an idea of whether Canadian inflation will sustainably return to its central bank's target of two percent. They explained that the indicators are the main drivers of inflation expectations.

"Central banks, they are transitioning to this idea that, yes, inflation is going to fall — we know that — but even if it drops to less than 2 percent, will that be sustained?" Capital Economics senior analyst Stephen Brown said, as quoted by Reuters.

Canada's December consumer price index (CPI) is due Tuesday, and analysts expect the headline inflation to fall to 6.3 percent, a 0.5 percent drop from the 6.8 percent headline inflation last November. Although a decline in headline inflation will be good news for the economy, the slowdown is mostly caused by falling energy prices.

Analysts also warned people not to expect significant improvement in annual inflation. Brown estimated that December's core inflation — which exempts food and energy costs — would show a 5.3 percent year-over-year increase, similar to November's core CPI. In November 2022, Canada's food prices recorded an annual increase of 10.3 percent, while housing was up 7.2 percent on a yearly basis.

The spread of price increases, three-month rates of core inflation and price increases for essential items within the CPI are important predictors of inflation expectations. Experts said that people could still see price increases in food, housing and gas — albeit at a slower rate than before — which had a pronounced influence on inflation expectations.

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Higher inflation expectations tend to lead to higher wage demands, especially in a tight job market, which can eventually boost price pressures. Brown said that at the moment, wage growth remained strong in Canada but "not too bad." December labor market survey revealed a 5.1 percent growth in average hourly wages.

Royal Bank of Canada assistant chief economist Nathan Janzen said wages could become a supporting factor of inflation in the future if they continued to grow. Janzen said central banks, including the Bank of Canada (BoC), were wary of this situation.

Regardless, economists expressed optimism that the economy could still avoid the extended loop of the wage-and-price dynamic. Brown said it was more important for the December CPI to display weaker price increases across the board.

"High inflation is having some impact on wages at the moment, but whether that is a concern for the longer term, 2024 and beyond, I think, is a different question," Brown said.

BoC's next move

The BoC aims to reduce inflation to its target rate by raising interest rates. Within the past nine months, it has increased the interest rates by a total of 400 basis points. The current interest rates range around 4.25 percent. Most investors and analysts expect the central bank to announce a 15 basis point rate hike in the upcoming rate-setting meeting on January 25.

On multiple occasions, the BoC has described its policy move as data dependence, meaning that it will look into the current progress of inflation from data and decide the next course of action. BoC deputy governor Sharon Kozicki said that the central bank was ready to take "bold action" if the data showed inflation had not cooled down.

Canadian Imperial Bank of Commerce economist Avery Shenfeld explained two risks in the BoC's policymaking. The central bank might not wait around to see the full impact of its rate hike and end up causing a worse recession. On the other hand, waiting around too long might increase the risk of inflation picking up again. Shenfeld said the BoC should find a balance between the two sides.