Nearing the End

The big questions in markets over the last few months have revolved around the number of interest rate increases that will be required to tame inflation and whether or not those increases will trigger a recession. Inflation has been, and continues to be, wildly above most global central banks’ targets. This is also true in Canada. Central banks, which are the designated inflation fighters in advanced economies, have in many cases responded aggressively (and belatedly) to inflation pressures.

The Bank of Canada’s policy rate is currently 3.25%. It was a mere 0.25% at the beginning of the year. This very large and rapid increase in policy rates reflects the Bank of Canada’s concern about the inflation outlook. Inflation is, after all, roughly 4 times what their official target is. We believe, however, that the Bank of Canada is nearing the end of this tightening cycle. Another 50-basis point move is expected in October, bringing the Bank’s policy rate to 3.75%.

At that policy rate, we expect inflation will gradually return to the 2% target over the next 18 months. Several factors point in this direction. It is now clear that many of the supply constraints impacting input and final goods prices are abating. This is not yet evident in some sectors, like the auto industry, but there is evidence pointing this broadly across the global economy. In addition, commodity prices have come off their highs, as clearly seen in the price of oil and gasoline. These factors suggest that the drivers of inflation over the last 18 months are starting to fade somewhat. It will nevertheless take time for inflation to return to the 2% target as other factors will push inflation up, offsetting some of the downward momentum from these past factors. A few stand out: food prices continue to remain elevated and are likely to remain so, service prices remain under pressure owing to capacity constraints, wage growth is accelerating given the incredible strength of the labour market, and rents are rising rapidly. On balance, we remain of the view that inflation has likely peaked in Canada and that a few more interest rate increases are required to put inflation on a clear path to 2%. We have to admit, however, that inflation has found ways to surprise to the upside in almost every single reading for almost the last 2 years. So, while there are good reasons to believe inflation will fade, the risks of positive surprises on inflation likely outweigh the risk of welcome downward shocks to the inflation outlook.

JEAN-FRANÇOIS PERRAULT joined Scotiabank in 2015 as Senior Vice-President and Chief Economist. He leads a team of Economists to support Scotiabank’s domestic and international business lines and clients from retail to capital markets, providing Scotiabank’s senior executives, business lines and customers with perspectives, insights and forecasts on economic, financial market and policy developments. Prior to joining Scotiabank, Jean-François held prominent roles with the federal government, the Bank of Canada, the International Monetary Fund and the World Bank.