The Consumer Price Index declined 0.2% month over month in August after a 0.4% increase in July. This was below the average economists’ forecast calling for inflation to remain at the same level as July.
In seasonally adjusted terms, headline prices were up 0.12% in August after a 0.25% increase in July. Year over year, headline inflation cooled from 2.5% to 2.0%, the lowest level since February 2021. Importantly, core inflation measures were also lower, 2.4% for CPI trim and 2.3% for CPI median. As a result, the average of the Bank of Canada’s two preferred measures of core inflation moved lower, to 2.4% from 2.5% in August.
As depicted in the supplied chart, headline inflation in Canada (red dotted line) is now at the midpoint of the Bank of Canada’s target range (grey shaded area of 1-3%). Notice headline inflation is now well below the Bank of Canada’s overnight policy rate of 4.25% (solid blue line). Recall, the Bank of Canada has recently reduced short-term interest rates by 0.75% with three separate 0.25% cuts since June.
What is most interesting and less obvious from the chart is current Canadian interest rates are the most restrictive they’ve been since 2006. Whether interest rates are restrictive or accommodative is determined by the Bank of Canada’s policy rate being above or below the neutral rate (interest rate which neither accelerates nor decelerates inflation).
When the Bank of Canada raises interest rates above the neutral rate, they are doing so to reduce inflation and slow the economy. Conversely, when the Bank of Canada reduces interest rates below neutral, they are doing so to stimulate the economy and potentially increase inflation if it has fallen below 1% which is the lower end of their inflation mandate (deflation can be more harmful to the economy than inflation).
With inflation now within the Bank of Canada’s target range and the economy slowing, the Bank of Canada is reducing interest rates to bring them back towards a neutral rate (neither accommodative nor restrictive).
The National Bank economic team’s estimate for the current neutral rate in Canada is 2.5-3%. This means the Bank of Canada needs to reduce interest rates by another 1.25-1.75% just to get to a point where rates are no longer restrictive. Given rates will remain restrictive for the near-term, the Canadian economy is expected to continue to slow.
Monetary policy (central banks adjusting interest rates and money supply to control inflation) has a delayed impact on the economy. The negative economic impact of increasing interest rates was delayed by 18-24 months and the positive impact of reducing rates, which only began in June, is likely to have a similarly lagged impact.\
In other words, the Canadian economy is expected to continue to slow well into next year with the impact of lower interest rates not being felt until late 2025 or early 2026. What we won’t know until after the fact is if the Bank of Canada reduced interest rates quickly enough to avoid a recession. With inflation now seemingly under control, I would expect voices calling for the Bank of Canada to cut rates more aggressively to grow louder in coming months.
Eric Van Enk is a wealth adviser & associate portfolio manager with National Bank Financial in Medicine Hat. He is a graduate of the University of Calgary, as well as a CFA charter holder with 20 years of financial markets experience in New York, Toronto and Calgary. He can be reached at eric.vanenk@nbc.ca
