Bank of Canada is too optimistic on inflation

After falling for nine months in a row, year-over-year inflation made a U-turn in April and increased to 4.4 per cent. This hike surprised most financial analysts who were expecting the rate to fall to 4.1 per cent from 4.3 per cent in March.

For many, this represents a setback in Bank of Canada’s attempt to wrestle inflation down to its two per cent target. The bank, however, seemed to consider April’s data an anomaly, and remained confident inflation is on its way down to three per cent this summer and to its target by late 2024.

The data, however, suggests that the bank’s assessment may be overoptimistic.

On the one hand, it appears that headline inflation may drop to three per cent this summer, even without an additional interest rate hike — which the bank went ahead with anyway this week, raising the overnight lending rate to 4.75 per cent. But on the other hand, the two-per-cent target seems unattainable unless the bank hikes rates further causing the economy to go into recession.

Let me start by pointing out that year-over-year inflation rises when the month’s percentage increase in the consumer price index (CPI) is greater than in the same month of the previous year. And the opposite occurs when year-over-year inflation falls.

For instance, CPI increased 0.7 per cent this April, while it rose 0.6 per cent in April of last year — and thus year-over-year inflation increased to 4.4 per cent from 4.3 per cent in March.

Interestingly, year-over-year inflation may decline even when month-over-month inflation rises, and vice versa.

So, does April’s data suggest inflation might be on the rise again? Not necessarily, since one swallow does not a spring make. Indeed, one month’s data is not sufficient to determine a trend and April’s data may indeed be just an anomaly. It’s more instructive to look at changes in quarterly data.

Inflation was relatively high in the first quarter of 2023 — the percentage increase in CPI was 1.4 per cent, equivalent to an annualized rate of almost six per cent. This is a significant three-month increase and confirms a rising trend: a mild deflation in the third quarter of 2022, very low inflation in the fourth quarter and high inflation in the first quarter of 2023.

Hence, inflation has been on the rise over the last three quarters despite a continuously declining yearover-year inflation.

Will this trend continue in the second quarter? Hard to say, but my crystal ball tells me that most likely second quarter inflation will be either similar to the first quarter or slightly greater — and definitely not smaller given April’s large monthover-month inflation.

If the second quarter’s percentage CPI increase were the same as in first, then year-over-year inflation would drop — as forecast by the Bank of Canada — to three per cent in June.

Why would it fall? Because this year’s second quarter inflation would be smaller than in last year’s second quarter — 1.4 per cent compared to 2.7 per cent.

Predicting inflation behaviour in the third and fourth quarter is, however, a more daunting task. In any case, my crystal ball tells me with sufficient confidence that year-over-year inflation will rise in both quarters. Why so? Because, as we have already seen, inflation was rather inexistent in the second half of 2022.

Assuming inflation falls to three per cent this summer, for yearover-year inflation to remain at this level the rest of the year, there should be a small deflation in the third quarter and very low inflation in the fourth. And this is very unlikely to happen.

Therefore, inflation will most likely

Inflation has been on the rise over the last three quarters despite a continuously declining year-overyear inflation

increase in the second half of 2023.

If so, what will the Bank of Canada do? Well, there is only one thing the bank can and will do: increase the policy rate. Both the bank and the Government of Canada are convinced that fighting today’s inflation is a job for the bank despite the mounting evidence to the contrary — and thus the bank will increase the interest rate. By how much? Well, another 25-basis-point hike in July will not do it. And thus, five per cent will not be the peak of the policy rate.

In my view, the misidentification of the source of today’s inflation leaves the bank with no option but to continue raising the rate until the economy goes into recession and the unemployment rate climbs sufficiently. And for this to happen, the rate must be increased until the real rate of interest — that is, the difference between the policy rate and the rate of inflation — turns significantly positive. How much? My crystal ball tells me that, in a futile attempt to save its credibility, the Bank of Canada will feel compelled to increase the policy rate to around six per cent before the end of the year.