The Decibel - Why the ‘last mile’ of inflation is the hardest

Episode Date: February 9, 2024

The most recent numbers show that inflation in Canada is at 3.4 per cent. Still above the 2-per-cent target, which is where the Bank of Canada would like it to be. And this last little bit of inflation is a critical period for the Bank in terms of adjusting interest rates.Mark Rendell covers the Bank of Canada for The Globe’s Report on Business and he explains what challenges remain to squeeze that last little bit of inflation out of the economy.Questions? Comments? Ideas? Email us at [e-mail]

In the last two years, Canada's economy has been on a wild ride, largely due to inflation. You know, inflation surged in 2021 and 2022. It went as high as 8.1% year over year. That was kind of peak in 2022. Mark Rendell is a journalist with the Globe's report on business. He covers the Bank of Canada. It's come down a lot. You know, in December, the annual rate of inflation was 3.4%.

Inflation has dropped a lot, but it's still not at 2%, where the Bank of Canada would like it to be. Shedding that last 1.4% may not seem like a big deal, but it actually is. And the reason it matters and the reason why we're all talking about it is because the Bank of Canada has raised interest rates a ton to get inflation under control. They raised it 10 times. And they've essentially held it at a level at 5% since last July. And so the question on everybody's mind is, you know, when is that going to start coming down?

When are we going to see some relief on mortgage payments? When are those interest rates going to start coming down and stimulating the economy? And the answer to that question is tied to the question of how long does this last mile of inflation take? Today, Mark is going to tell us about this last mile of inflation and explain what major challenges are ahead for the economy, the Bank of Canada, and Canadians. I'm Mainika Raman-Wilms, and this is The Decibel from The Globe and Mail. Mark, thanks for being here. Thanks for having me on. All right, so let's back up a little bit, Mark, and look at where we are at with inflation. So as you said, we've gone from a high of 8.1% inflation in 2022. We've got 3.4%

now. What's going on here? What's been bringing it down since then? Yeah. So the story of the rise of inflation in 2021 and 2022 was a story of goods prices. It was a story of oil prices. It was a story of all of these global factors that were really driving up prices. And we can think back to during the pandemic, you know, when everybody was locked at home, they couldn't spend on restaurants, couldn't spend on travel. Everybody wanted to buy exercise equipment, computers, furniture, that kind of stuff. Stuff you could enjoy at home. Yeah. Exactly. So you had this huge surge in demand away from services towards goods.

At the same time, you had all of these kinks kind of appearing in global supply chains because everybody wanted to ship all that equipment from China to the United States and Canada. You got this big backlog in shipping containers. Transportation prices absolutely surged, shortages of goods. So that rise in prices at the beginning that really drove inflation up was this goods story. So it's an oil price story, right? Oil prices collapsed in the beginning of the pandemic. They rebounded. And then after Russia's invasion of Ukraine, they absolutely skyrocketed. So you had this kind of twin oil prices, goods prices driving it up. Now, those things have largely reversed. That kind of all hit a peak. Peak inflation for goods, peak inflation for energy prices in mid-2022. And so a lot of the disinflation we've seen, a lot of this like road from 8.1% back to 3.4%

has been a story of supply chains improving, oil prices coming back down, all of that. So those are kind of a lot of global factors, right? You're talking about supply chain, shipping, like those were things that we were seeing kind of everywhere. That's exactly, right? You're talking about supply chain, shipping, like those were things that we were seeing kind of everywhere. That's exactly it. That's exactly it. And part of it is like when you look across a whole range of countries, inflation has followed a very similar track.

Even though the economic growth picture is being quite different country to country, a lot of this path up and then back down in inflation has been, again, driven by these global factors. So the question is then what's left of inflation? And the answer is, well, it's now largely a domestic story. And this is also why you get to the question of will this last mile be hard? Will it be harder than what we've seen so far for inflation? And what do I mean by a domestic story? It means that inflation right now is primarily in services rather than goods. So service prices are increasing rapidly. It's tied very much to wages, the pace of wage growth in Canada right now.

And it's also a question of overall demand in the Canadian economy is part of the story as well. So you've had this shift from all these global factors driving inflation to this last mile being primarily a question of domestic factors, which can be quite a lot more difficult for a central bank to tackle than just watching oil prices come back down and container shipping prices come back down. Yeah. And so you said it's more into services than goods. Can you give us an example of a service? Like, what's the difference there? Yeah, think about goods as the things that you buy, you know, the furniture, food.

Food is a non-durable good. You eat it, but it's still a good. Services are those things that you pay for that you're not, you know, it's not a physical thing. Okay, okay. So then, Mark, like, if we're looking at the big picture here, we've got this final mile of inflation that we have to get through. What are the economic indicators that are important to final mile of inflation that we have to get through. What are the economic indicators that are important to the Bank of Canada that they're watching? So at a very high level, the Bank of Canada wants to see the whole Canadian economy slow down.

It's kind of one of these funny things, like you think the Bank of Canada is on your side. And yeah, they are. But ultimately, their goal is price stability. And they're willing to slow down the economy to get to price stability. That's fundamentally how interest rates work, right? You raise interest rates, that increases the cost of debt, increases the cost of borrowing. Homeowners with mortgages are putting more money towards their mortgage. What that's fundamentally doing is slowing down consumer spending.

It's slowing down business investment. And the theory is that reduces demand for goods and services and slows down prices. So what they're looking for, again, is that broad base slowdown in the economy. And we've seen that. We have essentially since last summer, perhaps even earlier in last year, economic growth in Canada has stalled. It's flatlined. GDP isn't growing very rapidly at all. Unemployment has started to tick up. Job postings are coming down. Companies aren't hiring as many. That broad-based slowdown that the Bank of Canada is trying to achieve is essentially in place. But they're also looking at a bunch of other indicators to try to tell them, will these inflationary pressures be persistent? To look at that, they're looking beyond that generalized slowdown.

They're looking at things like the pace of wage growth. They're looking at people's beliefs about future inflation. Because if workers believe that inflation is going to be 5%, 6% in a year or two's time, they're going to go in there and ask employers for that higher wage settlement. If businesses believe inflation is going to be high, that's going to affect their price setting behavior. So there are a number of things that the Bank of Canada has not necessarily seen come back to line to where they want it to be. Okay. So I think this is what we should be focused on then, the stuff that has not quite gotten down. Let's dive into this and look at the CPI, the Consumer Price Index, Mark, which is essentially,

this is what we talk about when we're talking about inflation. This is like the basket of goods that we keep track of the price of those goods. So what is happening when we look at core inflation, when you take out the things that fluctuate a lot like gas and food prices? Yeah. So core inflation is a really important idea for the Bank of Canada. And when you look at core measures of inflation, the ones that the Bank of Canada likes the most, they've essentially been stuck in that 3.5% to 4% range for about a year. They're pretty range bound. Like they're going up, they're going down a little bit, but they haven't come down dramatically. And that's fundamentally what the Bank of Canada is looking at alongside those other indicators I mentioned earlier. They want to see these metrics that

capture these underlying pressures in the economy start to trend down from 3.5% back down towards that 2%. Now, they don't need inflation to get all the way back to 2% before they start cutting interest rates. Monetary policy works famously with long and variable lags, as economists like to say. What that means is if I raise interest rates now or I cut interest rates now, it's going to take many quarters to see the impact of that change. So if the Bank of Canada waits for inflation to get all the way back to 2%, it's going to have overshot. It's going to have hurt the economy more than it needed to.

Inflation is going to be below the 2% target. It's a bit of prediction that's happening here, when to jump in. Exactly. Exactly. Exactly. So it doesn't need that core inflation measure or overall inflation to be all the way back to 2%, but it needs to be pretty confident that that number is on a downward track. And so that's one of the key kind of pieces of data that they're tracking. We'll be back in a minute.

I guess it comes back to the, like, why are we getting stuck here? Like, we talked a little bit about the cost of services, but what else is causing this? So the biggest driver of inflation today is actually the shelter component of inflation, housing costs. And they're going up very rapidly. And there's a bunch of things in the shelter component of consumer price index inflation. There's rents. Rents are going up very rapidly right now. 7% year over year in December. There's the mortgage interest cost part of it. So that is the amount that people pay on their monthly mortgages. That's gone up a lot. Now, that's kind of a funny piece of the puzzle because mortgage costs are directly tied to the Bank of Canada's own interest rate decisions, right? When they hike interest

rates, that pushes up the amount that people pay on a monthly basis. And mortgage interest costs are up 30% or roughly 30% year over year. So that's a huge driver of the shelter component of inflation. Bank Canada is not necessarily worried about that because it has direct control over essentially what happens to mortgage interest costs. When it starts lowering interest rates, that will bring down mortgage costs as well. That's a direct result that will happen there. It's exactly it. House prices aren't directly captured in the shelter component of the CPI. StatsCan treats homes as an asset rather than a good or a service. But there's ways in which they can come to kind of a proxy for house prices, and it ends up in the shelter part of the index.

So the biggest thing is the rent part of the story, right? That's the bit that's not directly in the Bank of Canada's control, like mortgage costs are. And that is tied to structural imbalances in the housing market. So that is tied to very rapid population growth, a very high level of international students, temporary foreign workers. Population of Canada grew by well over a million over the past year. So that's a very high demand for rental units coming into the market. At the same time, we have perennial problems with housing supply. There just aren't enough homes being built. So literally just like not enough supply,

too much demand. That's exactly it. Members of the Bank of Canada, Tiff Macklem, the governor, has made a number of remarks in the past couple of weeks saying, look, monetary policy isn't going to solve the housing affordability problem. We need governments to step in and, you know, do more to improve home supply, because simply raising interest rates or cutting interest rates isn't going to do what needs to be done to get, you know, the housing market back into balance. Okay, but so I understand that. And I can see so he's saying, you know, they can't affect this, this whole slew of factors, especially rent, but as you said, they can affect affect this whole slew of factors, especially rent. But as you said, they can affect mortgage rates, right?

So, I mean, why not just cut rates then if that'll at least drop mortgage interest payments and possibly get builders to build more housing because it'll cost less? Like, why not just do that at least? Yeah, they're in a real pickle on this one because, you know, as soon as you start cutting interest rates, house prices are going to go off. As soon as there's even a whiff of rate cuts coming, people are going to jump back into the market. We saw this last spring when they announced a quote-unquote conditional pause on raising interest rates, and the real estate market just took off. And they ended up actually having to raise interest rates two more times last summer. So, you know, they're facing other binds too, like high interest rates are cooling demand for housing, but they're also affecting supply because developers are less likely to build buildings if their costs are higher, if their cost of borrowing is higher. You know, demand, one of the big things developers need is, you know, they're looking for pre-sales of condos and things like that, but pre-sales have collapsed. So it's one of these interesting things where they're trying

to balance the supply side and the demand side. They're trying to take that demand out of the market by keeping rates high, but they also risk, you know, choking off supply of new homes, which they have said quite explicitly, the only thing that is going to solve housing affordability problems long-term in Canada is a big increase in housing supply. This makes me wonder, like there is such high demand for housing in this country, especially in certain pockets of the country. Like isn't I guess isn't the rush to the housing market going to happen no matter when the Bank of Canada cuts rates, Mark? Like does it matter if they cut them now or later? Like aren't we still going to see that rush to the housing market? I think the answer is probably yes. I mean, we've already seen

jump in sales in some major markets in Toronto, Vancouver, elsewhere. Again, people have been sitting on the sidelines waiting for mortgage rates to come down, right? It's very difficult if you're a would-be home buyer, you don't own a home, and you want to get into the market. It's very difficult to qualify for mortgage at these higher rates right now. You talk to a lot of real estate people, and they're expecting this rebound in demand as interest rates come down. It's not just the mechanical dropping of interest rates, making mortgages affordable. There's also a psychological component, right? People have been waiting to see if the bank's going to raise interest rates further because that theoretically could lead

to another leg down in home prices and they don't want to be caught. You don't want to be the guy who goes out and buys a house today. Bank of Canada raises interest rates another 1% and house prices drop $200,000 from what you just purchased at. So there's been this sense in the market that people

are waiting to see rates stabilize and then start to come back down before reentering the market. The Bank of Canada has said pretty explicitly in January, further interest rates are quite unlikely. It really is a question now of how long do they hold them steady and then they start cutting. And that is already leading to people bustling to get into the real estate market. And of course, while they're waiting and biding their time, they're still in the rental market, which is putting more pressure on the rental market. That's exactly it. That's exactly it. It's more than just the population growth story that's driving up rents. It is also the fact that if you're a young person who may otherwise be a

home buyer and you can't buy a home right now because mortgage rates are very high, you're going to stay in the rental market for longer. So that's, again, putting more pressure on the rental market, pushing up rents. Yeah. Okay. So Mark, there's a lot happening with housing and inflation, but I also want to ask you about wages because some people have been seeing raises in the last few years. So I'm wondering, what kind of effect is that having on this last little bit, this last mile of inflation? Wage growth is a huge component that the Bank of Canada is looking at right now. Wages have been rising at around 4% to 5% for more than the past year. Now, that's great news if you're a worker. Throughout the inflation surge, people really saw their earnings whittled away, right?

Inflation was rising faster than their earnings. So this rebound in or pickup in wages over the past year is great news. It's great news if you're a worker. It's not great news if you're a central banker, because central bankers don't really think you can have wages grow at 4% to 5% and also have 2% inflation. You essentially need productivity to pick up quite a lot per worker if you're going to get wage growth at that kind of pace without inflation coming in. Okay, so let's explain that just a little bit here. So how does productivity play into this?

Yes, productivity is its output per worker, right? And if labor costs are growing very rapidly, you know, if wages are going up rapidly, but individual workers are also producing more, you know, companies don't necessarily have to pass those higher labor costs along to their end customers. They're not going to necessarily increase their prices. If, however, you know, labor costs are going up and companies aren't making more money because their individual employees aren't becoming more productive, for a while they can absorb those extra labor costs in their profit margins. But eventually they're going to go, OK, we need to raise prices. We need to push prices up. OK, so if wages are growing, companies are not producing more, but they're paying more for their workers, then eventually they're going to pass that cost onto the end consumer. And that is what the Bank of Canada is worried about then.

That's exactly it. What is inflation? Inflation is increasing prices, right? So if you have a lot of prices that are rising pretty rapidly because businesses are passing along increased labor costs, you're going to get inflation. Now, part of the wage growth issue is, again, it's people catching up for past inflation. It's not necessarily a sign of future inflation. But there are some signs. The labor market is weakening. Job postings have dropped. Unemployment's moving up. When you look at business surveys, they're saying, yeah, we're probably not going to be raising wages as much over the next year. So there are a number of things, signals that suggest that wage pressures may not be as strong going forward, which again, good for central

bankers, maybe not so good for workers. Yeah. I guess the other option is businesses could eat that cost and not pass that on to the consumer, but not likely. Well, they could do that. But again, a business is only going to compress its profit margin so much before it raises prices. So, Mark, we've talked about a lot of things, but what are experts saying about how feasible getting this last mile down is? Like, when might inflation actually get down to 2% in Canada? That's the million dollar question. People expect inflation to keep trending down. It's really a question of how long is it going to take.

Bank of Canada's latest projections sees inflation hovering around 3% until the middle of the year, coming back down to around 2.5% by the end of the year, and then back to the 2% target next year. Now, there could be a number of upside surprises that could keep inflation higher for longer. If you do see this surge in the real estate market in the spring, that could make a difference. There's a bunch of, as much as these global supply chain issues have very much improved over the last two years, there are new things that are emerging. Shipping costs are going back up again because of attacks on shipping in the Red Sea. Oil prices again could surge if there is a major geopolitical shock in the Middle East. The flip side, and on the other side of it, is you could see inflation come down much quicker

than people expect. If it turns out the high interest rates do plunge the Canadian economy into a recession, which they haven't done yet, the Bank of Canada is going to start cutting interest rates pretty quickly. Inflation is going to come down more rapidly. What does all this mean for when the Bank of Canada might actually cut interest rates? It really comes down, as we were saying, to what happens in the broader economy. Markets are always trying to bet on when an interest rate is going to come. Last fall, kind of near the end of last fall, everybody got really excited that central banks were about to pivot. Everybody thought the Fed would start cutting in March. Bank of Canada would start cutting in April. That's been reversed. A lot of that kind

of narrative has been reversed because we've seen some stronger than expected GDP data. Inflation's ticked up a little bit. So right now, the going bet on Bay Street is that the Bank of Canada will make its first rate cut in June. Some economists are now saying it might even wait a little bit longer. You had a former deputy governor of the Bank of Canada come out last week and say he thought a July rate cut might be more likely. The best bet is sometime around the middle of the year. But again, it could be earlier. We could see an April cut if the data weakens very rapidly. We could see the Bank of Canada sitting on their hands until late summer or maybe even early in the fall.

It really is at this point, it's a question about what happens to the inflation data, what happens to the economic growth data, and how that all comes together. And the Bank of Canada has said pretty explicitly, we just don't have enough information yet. We're sitting on our hands. We're on hold. We're probably not going to raise rates, but we don't want to cut them yet until we're more confident, until we have some assurance that we're there. And that really is a, you know, it's a wait and see, watch the data kind of thing. Mark, thank you so much for being for today.

I'm Maina Karaman-Wilms. Our producers are Madeline White, Cheryl Sutherland, and Rachel Levy-McLaughlin. David Crosby edits the show. Adrian Cheung is our senior producer. And Angela Pachenza is our executive editor. Thanks so much for listening, and I'll talk to you next week.