'It's not really an environment for the bank to be raising rates at this point': Kavcic on the BoC

[00:00:00]Canada's inflation rises to 3.2% year-over-year in May. That's above estimates. Gas prices pushed inflation to its highest since December of 2023.

[00:00:10]Here to discuss what that means for Canada's economy is Robert Kavcic, senior economist at Capital Markets.

[00:00:16]Good morning. Thanks for joining us.

[00:00:19]>> Great. Thanks for having me.

[00:00:20]>> So, 3.2% year-over-year. Is this in line with your expectations?

[00:00:25]>> Um well, it was a little bit higher than than we were expecting, but I wouldn't call it much of a surprise to be honest.

[00:00:30]So, we were we were kind of staring down the barrel of 3% plus inflation for a couple months since the conflict in the Middle East broke out. So, um if we're splitting hairs, yeah, it was a little bit stronger than expected, but not really a a big surprise. And And And frankly, not really something for the market to to get overly stressed about given that we're sitting here in June and gas prices have already come tumbling down on on word of an agreement. So, this is, you know, from that perspective, kind of old news.

[00:00:54]>> Okay, yeah. So, we're seeing the trickle-down effect kind of of what we've been seeing over the last couple of months, obviously, with gasoline. I mean, when you take away gasoline, food prices as well, what's your thoughts on core inflation versus headline inflation?

[00:01:06]>> Well, that's where the story gets a lot better, right? So, if you're looking across three or four different core inflation metrics, on average, they're kind of bouncing right around the 2% mark, where the Bank of Canada wants it. If you look even over the last 3 months or so, I think underlying core inflation is running even a little bit softer than 2%, partly because we did have a couple months where where core inflation was actually very subdued. Um so, from that perspective, and like we we know the Bank of Canada is going to strip out any noise related to temporary spikes in oil prices or temporary changes in taxation.

[00:01:38]They're going to be a little bit more in tune to whether or not higher gas prices are are passing through to underlying core inflation. At At this point, it really doesn't look like they are. And especially now with gas prices coming down into June, I think I think most of the concern on that front is is probably kind of melting away.

[00:01:55]>> I think I know what you will say about this, but what should investors focus on more? Is it that 3.2% or the 2%?

[00:02:02]>> Uh no, for sure it's it's that 2%. It's the underlying core, especially given what we know is happening right now on the ground. Um again, I would kind of reiterate that like the bank is going to is going to kind of just just just keep its kind of hawkish feathers up in a sense to make sure that they don't uh you know, get in a situation where where they sound too dovish in an environment where you know, gas prices are still elevated. We still have, you know, 3-4% food price inflation, which is kind of rooting into the psychology of Canadians. So, they're going to be a little bit defensive um with how they communicate this in that they don't want those ex-expectations on inflation to get embedded. They also don't want to see pass-through to broader core measures.

[00:02:43]Um but I you know, the numbers that we're seeing on the ground, we're we're just not there.

[00:02:47]Maybe there were a few pockets, like things like travel services and airline prices where you can argue that, "Okay, higher gas prices are are are pushing through." But, we just don't see broad enough um evidence that that it's that it's that it's rooting into underlying core. So, um the takeaway here would definitely be on on the softer core measures.

[00:03:05]>> And you say you see the Bank of Canada holding through 2026. Is that right?

[00:03:11]>> Yeah, we we we see them pretty firmly on hold. We probably push back a little bit against some of the market pricing. Um the market pricing for rate hikes later this year is dialed back down. We've we've been consistently pushing back on that. Um even, you know, the bank's going to be watching for for things like how how much this energy shock is broadening out into price pressures across the spectrum. And even even in May, like you look across 150 or so components, third of them are sub 1%, a third of them are north of 3%, roughly a third of them are kind of bundled in that 1 to 2% range.

[00:03:44]So, it looks pretty pretty safe on that front from their perspective. Um and you combine that with the fact that we did, you know, just come off two quarters of negative economic growth. The economy is struggling to grow above potential probably through Q2 and Q3. It just It's not really an environment for for the bank to be raising rates at this point. I don't think.

[00:04:03]>> Okay, so you say you push back on any kind of market the market pricing and rate hikes for the rest of this year.

[00:04:08]What about in early 2027? Cuz we're already talking about that, obviously.

[00:04:12]Some believe that, you know, we could see a rate hike early 2027. What do you think about that?

[00:04:17]>> Um well, it it's certainly not off the table, especially considering the starting point here. And the starting point with the bank at 2.25 would arguably be be at the lower end of what they would consider neutral. So, look, if if if the US economy continues to grow, if the Federal Reserve actually pivots towards some tightening on the back of this big AI CapEx boom, um if importantly we come to a resolution on Canada-US trade and business confidence improves through the fall into next year, um it's it's entirely possible. We just kind of don't see the evidence on the ground for for that to be taking shape necessarily in 2026.

[00:04:53]2027 conversation, sure, that could that could be alive.

[00:04:57]>> Got it. Okay, so going back to inflation, because you say gas prices are old news at this point. And I know you already explained why. Um but if there is no resolution to this conflict, if this this these talks fall through, and we see oil prices continue to spike again, what does that mean moving forward for the Canadian economy? Or are you not too concerned because you're more focused on core inflation?

[00:05:20]>> Well, no, that would be a concern, for sure. Like, if this conflict was to, let's say, reignite and and persist through the summer, and we had another leg up in gas prices, we got stuck with 3% plus inflation through the summer into the fall. Um you know, after 3, 4, or 5, 6 months of that, there is a legitimate risk that that does filter down into broader core inflation, and kind of broadens out across price pressures more economy-wide. Um and and and for sure, the Bank of Canada, like they've told us very clearly that they're going to be very tuned in to whether or not that's happening. So, yes, it's a risk.

[00:05:54]Incrementally, like given the given what we're seeing um with communication from the US and Iran over the last week or so, given what we're seeing in the market with oil prices are today, that's not the case, but for sure that risk could could come back.

[00:06:09]>> What are the key kind of inflation if you're watching for kind of key inflation numbers moving forward? What are what are some of the the factors that you're looking for over the next couple of months? You already mentioned Canada US trade is one as one major factor you're going to be watching for to see which way things go. Um, I'm assuming oil prices as well. What else?

[00:06:27]>> Yeah, yeah, those are the straightforward things. Beyond that we'd be looking at a couple of things. For sure food price inflation grocery price price inflation is really not looking all that good.

[00:06:38]We're still kind of stuck in that 3-4% range and we saw frankly pretty strong number in May as well. So, that's one thing that really does impact psychology of of Canadian households, right? Not only just like gas prices flashing at them in red which they see every day as they drive to work, but when they go to the grocery store they see that pretty clearly and that roots in expectations. So, that's that's a one thing.

[00:07:02]Beyond that like if you look at things like core goods inflation pretty subdued and and not really showing a lot of evidence that we're seeing broader price pressure. Service inflation too is actually become pretty subdued and one big component of that would be what's happening on the housing front.

[00:07:17]And the housing front is is actually a very disinflationary force in Canada right now that is um, it's it's one of those that once it gets moving it tends to persist for quite a bit of time and we're talking about things like rents coming down and mortgage interest costs coming down.

[00:07:31]So, that's going to persistently weigh inflation down over probably the full next year at least even as some of these other pressures kind of kind of work their way around in the background.

[00:07:41]>> For sure. Okay, we'll leave it there.

[00:07:42]Robert Kavcic, senior economist at Capital Markets. Appreciate your time.

[00:07:46]Thanks for joining us.

[00:07:48]>> Sure thing. Thank you.