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Is a Slowing Global Economy Enough to Cool Core Inflation?

14 August 2023

Last week saw some market movements – the TSX rose a half of a percent on higher oil prices, and yields were up a few of basis points across the yield curve – but it was a quiet week otherwise. 

Statistics Canada’s update on international trade and investment activity was the only data release for the week. June numbers show imports remained strong, while exports weakened, reflecting a slowing global market. While net exports contributed to growth in the first half of the year, we expect that trade will be a net drag on growth in the balance of the year with the trade deficit at levels not seen since late 2020.

On the cost of living front, inflation has moved below the Bank of Canada’s upper band of 3%, but with core inflation remaining sticky, the journey to 2% will be long. Indeed, in its July Monetary Policy Report, the Bank pushed its expected timeframe of achieving its 2% target from the end of 2024 to mid-2025. Headline inflation is likely to trend up with higher food and energy prices. (Headline inflation refers to all goods, services and commodities in the economy; core inflation refers to all goods, services and commodities excluding food and fuel.)

Incoming data has been supportive of the Bank remaining on the sidelines, and we believe July’s quarter-point hike was the last of this tightening cycle. Most economists expect the Bank to keep the overnight rate unchanged until the second quarter of 2024, so borrowers with variable rate mortgages can expect another nine to twelve months before any relief is in sight. Given OSFI is focused on this segment of the market, it’s unlikely that banks will move their lending margins. Fixed rates will adjust sooner – likely by the fourth quarter – but adjustments will be modest. We’re not likely to see 5-year bond yields below 3% until Q3 2024.

There were signs of underlying improvement in US inflation last week. While the headline number was up 0.2% to 3.2% for July, the annual core inflation rate declined from 4.8% to 4.7%. While there is expectation that the Fed may increase rates in September, recent comments from some voting members of the Federal Open Market Committee (FOMC) have been less hawkish.

The evolution of US inflation will depend significantly on the housing market, which plays an outsized role in the Consumer Price Index (CPI). (Housing represents roughly one-third of the value of the basket of goods and services the Bureau of Labor Statistics (BLS) uses to track inflation in the CPI.)

Economists expect that housing inflation will continue to fall in the balance of this year and further reduce overall inflation. This impact is a result of the way rental prices and housing costs are captured in the CPI. For housing, CPI measures the cost of the consumption value of a home—the shelter provided—not the change in the value of the house. For rents, the lag between the average rental index – the CPI for rents – lags behind the measure for new leases by about 12 months. New leases have been falling, and given that the average rental index accounts for about one-third of total inflation, overall inflation could decline as well.  The underlying trend is positive as inflation measures that remove energy, food, shelter, and used cars are getting much closer to the Fed’s target of 2%.

Independent Opinion

The views and opinions expressed in this publication are solely and independently those of the author and do not necessarily reflect the views and opinions of any person or organization in any way affiliated with the author including, without limitation, any current or past employers of the author. While reasonable effort was taken to ensure the information and analysis in this publication is accurate, it has been prepared solely for general informational purposes. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author. There are no warranties or representations being provided with respect to the accuracy and completeness of the content in this publication. Nothing in this publication should be construed as providing professional advice including investment advice on the matters discussed. The author does not assume any liability arising from any form of reliance on this publication. Readers are cautioned to always seek independent professional advice from a qualified professional before making any investment decisions.

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