Monex forecast: Core inflation pressure is rising, Bank of Canada may take a hawkish stance next week

Nick Rees, currency market analyst at Monex Europe, said rising core inflation pressures would likely mean the Bank of Canada will take a hawkish stance next week.

Canadian inflation accelerated in December, rising to 3.4% year-over-year as expected, but still up 0.3 percentage points from November's 3.1% reading. Overall price growth is expected to rise sharply due to adverse base effects. In this case, gasoline prices are the main reason, with December data showing a year-on-year increase of 1.4%, after falling -7.7% year-on-year last month. More concerning for the Bank of Canada, however, was the rise in core inflation readings, with both the core revision and core median inflation readings exceeding expectations.

The Bank of Canada may view this increase as justification to keep interest rates higher for longer, posing a risk to market expectations that the Bank of Canada will ease policy in early 2024.

However, if the Bank of Canada does this, it will come at the expense of growth, which in turn will lead to a rapid cooling of inflation, given that the economy is already on the brink of recession.

Overall, while today's data suggests the Bank of Canada may remain tighter than consensus, this is not a positive environment for the Canadian dollar if it comes at the cost of the Canadian economy slipping into a deep recession.

     While today's data shows an increase in year-over-year price growth, it's worth noting that the monthly data continues a trend of softer growth. Monthly prices actually fell by -0.3%, recording the lowest reading since December 2022. And, while base period effects on gasoline prices may have caused year-over-year prices to rise in December, monthly prices actually fell -4.4%. However, after stripping out the impact of swings in energy and food prices, inflation actually rose by just 0.2% in December, taking annual core CPI growth in 2023 to just 3.4%, following November's 0.3%.

Overall, this suggests that inflation in Canada has fallen to relatively tame levels relative to other countries. However, a rise in core revisions and core median inflation readings, which policymakers are closely watching, will be a cause for concern for the Bank of Canada. Both readings exceeded expectations, coming in at 3.7% and 3.6% respectively.

However, the upward revision to the core median estimate means December's reading will be the same as last month. Even so, on a three-month moving average annualized basis, both indicators rose in December, with the average rising from 2.9% a year earlier to the latest release of 3.6%. That means the Bank of Canada's preferred measure of core price growth is now outside their tolerance range, a fact that could support policymakers' continued hawkish rhetoric next week.

Looking ahead, there is reason to expect inflation to fall faster than today's data initially suggested.

Specifically, markets continue to see softening in the labor market, a key point highlighted by the Bank of Canada's business outlook survey released yesterday. Additionally, the survey noted that output prices will moderate in the coming months, with fewer companies now planning unusually large price increases due to weaker demand and increased competition. Granted, inflation expectations remain elevated, but it's worth noting that most businesses say they are adjusting their behavior to this outlook. Weaker economic growth will also have an impact on inflation, especially if the Bank of Canada keeps interest rates higher in response to the latest inflation data.

In fact, given the recent hawkish comments from Bank of Canada policymakers, these data provide them with enough data to continue this stance at the upcoming policy meeting on January 24.

However, weak economic activity has intensified pressure on price growth, and overly conservative policies may cause unnecessary damage to the Canadian economy.