Inflation cooling seems to be spreading to more components of the economy, according to a new analysis
In the coming months, the Bank of Canada is likely to begin its policy rate cuts despite sticky inflation continuing to exceed the institution’s 2% target – but TD economists are warning that this will pose a significant challenge in the central bank’s attempts to communicate to the public and anchor household inflation expectations.
“The central bank will have to cut interest rates in the face of stubbornly high shelter costs because to neglect to do so risks running the economy aground,” TD said in a new analysis. “In turn, this could amplify household inflation expectations, which are sensitive to developments in home prices and perceptions of affordability.”
Managing expectations on this front will be especially crucial as evidence is mounting that inflation cooling is spreading to more components of the economy.
“The share of products where inflation is less than 3% has grown, and the share in outright deflation territory is also on the high side relative to the pre-pandemic period,” TD said.
“The Bank of Canada will need to convincingly pivot its public communication to emphasize that shelter costs do not define broader inflation trends in Canada. To neglect to do so runs the risk of leaving rates too high for too long and sacrificing too much economic growth.”
TD added that in concert with this, the BoC must navigate the delicate balance between addressing the risk of prolonged shelter cost growth and re-establishing consumer inflation expectations.
“While we currently forecast home price growth to be in the single digits this year and next due to the deterioration in affordability, there is upside risk to this forecast once interest rate cuts get underway, which would put upward pressure on shelter inflation.”
BMO chief economist Doug Porter said that the Bank of Canada’s rate increases throughout 2022 and 2023 would probably continue to stymy chances of a significant economic upswing.
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Still, cuts will have to happen eventually, with TD noting that any lowering of the policy rate will need to take place while annual inflation is still at the upper end of the BoC’s 1%-3% range.
“The real interest rate is already in restrictive territory,” TD said. “Duration and level will come under the microscope with each passing month. A real policy rate of 2% (adjusted for the neutral rate) is consistent with past recessionary periods and will only push higher as inflation continues to ease.”
Given current conditions, the central bank has compelling reasons to gradually ease its “foot off the pedal.”
“While the Bank of Canada does not manage the supply-demand imbalance of housing, it still needs to consider whether its interest rate setting contributes to amplifying financial risks,” TD said.
“Leaving interest rates at the effective lower bound for too long following the pandemic fuelled a high uptake in variable rate mortgages and an escalation in household mortgage debt. Now the central bank must keep those risks top of mind at the other end of the spectrum in leaving rates too high for too long.”
