Headline inflation fell from 4.4% to 3.4% YoY in May, matching consensus expectations.
As we noted in several past analyses, the expected drop was largely driven by base effects, overshadowing the still firm monthly pace, which also met expectations at 0.4% MoM. Broadly speaking, there are some early signs of optimism in the data. Monthly inflation was a tenth weaker than 0.5%—the average from January to April—and considerably softer than last month’s 0.7% gain. Additionally, the annualised 3-month average of core-median inflation fell by two tenths of a percent to 3.6%, although the same measure of core-trim showed little progress at 3.85%. The breadth of inflation fell, with around half of the components running above target in May, compared to roughly three-quarters when averaged over the past three months. This could be an early sign of cooling price pressures after months of re-acceleration, but the fact remains that the monthly pace of price increases was still twice as strong as it would be if inflation were back to normal and the underlying core measures remain too high for comfort.
For this reason, we do not think this single improved report is enough to prevent the Bank of Canada from hiking rates again in July, but it reduces the risk that they will take the overnight rate above 5%. This merely confirms our view on the BoC’s implied rate path, with the risk of inaction at July’s meeting now centred on the data released over the next two weeks.
On a monthly basis, falling energy prices were the primary reason for a weaker print. Energy costs fell by -0.8% outright, with gasoline also falling by -0.8%, fuel oil down -10.1%, and natural gas falling by -1.8%. Unfortunately, energy costs are set to rebound in June. Gasbuddy suggests that the average price of gasoline is up by 4 cents per litre from May, while futures contracts point to steady increases in fuel oil and natural gas as well. Also driving some softness in the data was a broad pull-back in goods prices, which in recent months had surged once again after months of going dormant, puzzling officials. Goods prices are now rising in line with their historical average of 0.1% MoM. In addition, interest-sensitive items such as cars (-0.1%) and furniture (-1.1%) saw prices fall outright, weighing on goods inflation and suggesting that interest rate hikes are indeed having some effect.
A picture tells a thousand words: put simply, the BoC’s favoured measure of core inflation is still uncomfortably high to halt the hiking cycle again
Despite the aggregate improvements, several signs still warrant caution. Services inflation continued to grow by 0.5% MoM, while discretionary items such as hotels (+15.6%), travel tours (+3.8%) and food at restaurants (+0.6%) suggest that Canadian consumers aren’t cutting back on non-necessities.
Recreation costs specifically rose by 2.3% MoM, more than the annual 2% quota in May alone. This will strike concern amongst BoC officials, who are now showing greater sensitivity to growth conditions as the output gap isn’t narrowing as quickly as previously expected.
In response to the data, the Canadian dollar initially weakened as algos reacted to the top-line figures, but despite increased volatility, settled back down where it started a few minutes ahead of the report.
While FX traders aren’t buying into the idea that a further hike from the BoC is in question following today’s inflation report, overnight index swaps are taking a more cautious view ahead of further key data releases over the coming fortnight. Pricing of a hike at the July meeting has now moderated to around a coin flip, whereas the odds of a hike were about 2 in 3 over the past week. Interest rate traders are responding similarly to the money markets, with Canadian 2Y and 10Y bond yields down 8 and 5bps, respectively.
Jay Zhao-Murray, FX Market Analyst