Inflation concerns not misplaced, but shouldn't be overstated

As Canada’s growth accelerates along with the pace of vaccinations, attention has turned to pent-up household demand and its potential impact on prices. With stimulus dollars flowing and prices for commodities and building products on the rise, concerns about inflation have emerged.

The view that prices will rise isn’t misplaced, but it shouldn’t be overstated. The Bank of Canada will look through spiking energy prices relative to year-ago levels near-term, but we also expect core measures of inflation to drift up to the 2% inflation target or above in 2022. That, combined with a much-improved economic backdrop, will likely spur the central bank to gradually begin to raise its key interest rate from its current, exceptionally low level. However, price growth in Canada isn’t likely to break un-sustainably higher over the longer term, as long as the multiple actors in the economy continue to expect that the central bank will act to keep prices in check—sentiment that so far shows few signs of changing. Retail competition too will exert downward pressure on prices.

There will be price increases

An increase in headline inflation in the coming months will mostly reflect a continued rebound in oil prices tied to the strengthening of the economy, on the back of weak year-ago comparable. Gasoline prices are running almost 70% above the lows they hit last spring. Outside of energy products, prices for raw materials and some consumer goods—notably building products and furniture—have already jumped, reflecting robust demand for housing and Canadians’ newfound nesting instinct.

Monetary policymakers tend to look through transitory energy-price volatility. But we do expect the firming in underlying price trends, along with a stronger economy, to prompt the Bank of Canada to hike rates next year. Households are sitting on a record savings pile built up as a result of hefty government income supports and sharply reduced spending opportunities. Demand, particularly for hospitality and travel services, is set to jump as more of the population is vaccinated. That bounce-back in demand could outpace supply growth as businesses reopen, resulting in higher costs to consumers.

Despite eye-catching CPI readings, runaway inflation is more of a perceived threat

Even though they make headlines, large consumer price increases have been the exception rather than the rule. About half of the goods and services in the CPI basket increased by 2% or more in February. This compares to almost 55% in 2019. Energy-price inflation readings will ease later this year as the huge oil price drop a year ago fall out of the year-over-year price calculations. Meanwhile, the complex nature of international supply chains is likely to prevent rising input prices from having a rapid, broad effect on consumer prices. Simply put, the multiple layers in these production chains tend to buffer much input-price volatility along the way.

The larger risk is a shift in inflation expectations

A more dramatic and lasting break higher in inflation—the kind of shift that would require the Bank of Canada to tap the brakes on the economy more aggressively via faster interest rate hikes —is much less likely, as long as business and household inflation expectations remain well anchored. Inflation expectations in Canada and elsewhere are, to an extent, a self-fulfilling prophecy. If convinced that the Bank of Canada can and will step in to keep inflation within its target range, businesses tend to be more hesitant to pass on increased costs to consumers. Workers also adjust their wage demands based on what they expect inflation will be.

Market-implied inflation rates in Canada have still increased, although not as sharply as in the U.S. where near-term government stimulus spending will be larger. Outside bond markets, most economic forecasts are for non-energy inflation to drift higher into next year but still to around a 2% rate. The latest Bank of Canada survey suggests more than 80% of businesses expect inflation to remain within the 1% to 3% target range over the next two years under the central bank’s watchful eye.

Retail competition will also keep a lid on price growth

Widely held views around the direction of prices aren’t the only force that will keep inflation in check. Retail competition will too. Last year, broader goods-price inflation remained well-contained compared to pre-shock levels, despite a rebound in demand that began in early summer. Prices charged by Canadian retailers (excluding gasoline) were running about 1.2% above year-ago levels at the end of last year despite strong demand (the quantity of goods purchased was up 3.8% year-over-year). That likely has to do with increasing competition in the retail space, both online and in stores. That competition is not going away, and if anything has only been fueled by the rise of e-commerce. Retailers will continue to duke it out in the years to come, with consumers likely to benefit from price competition.

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This report was authored by Senior Economist, Nathan Janzen, and Economist, Claire Fan.

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