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This article was written by Elevate Senior Advisor, Peter Hall, and a similar version was featured in the Financial Post on August 22nd.

Conventional wisdom has it that the Bank of Canada is not done. After a staggering series of rate hikes, the Consumer Price Index (CPI) released on Tuesday jumped from 2.8% in June to 3.3% in August. Markets had expected an uptick, but not this much. Market watchers prominent in the immediate headlines chorused that on balance this was sour news for the central bank, increasing the odds of further rate hikes. Are they right?

A first look at the details wasn’t great. Spiking tourism costs and outsized gains for both energy and transportation prices were key factors behind monthly overall price growth, which at annual rates rose to 7.1% in July. Single months can pop like this; however, average the annualized growth over four months, the problem is glaring – price growth is stuck at 5.5%, way above the Bank of Canada’s 2% target.

Core inflation – which nets out particularly volatile items – provided some solace to market-watchers, but not much. While core price growth moderated in the month, each of the popular measures was still well above the Bank’s comfort zone. The message is still a hard one.

Or is it? What wasn’t discussed in immediate news flashes is that certain key groups in the CPI basket are either deflating or in disinflation territory. The cost of household operations, furnishing and equipment – a category that accounts for almost 15% of the basket – has fallen by an average of 0.5% per month for the past three months. That’s an annualized drop of 5.9%. Ouch. It’s not alone. The clothing and footwear category has tumbled by 2.8% in the past two months. Meanwhile, health care costs have flatlined. About a quarter of the basket is already hard-hit.

What also seemed to bypass the collective banter is the impact of interest rates themselves. Data plainly show that mortgage interest costs – a line-item in the CPI – are up a whopping 30.6% compared with July 2022. Nothing else in the Index is even close.

The eye-popping number isn’t a result of some dated anomaly in the data. Monthly mortgage interest growth is still on an annualized double-digit streak that is into its fourteenth month, currently averaging 24%. Momentum is so strong that if monthly rates immediately calmed down to, let’s say, 2% (highly unlikely, given the timing of interest rate increases), the headline year-to-year number for mortgage interest would still be up by double digits until next February, and wouldn’t be in the Bank of Canada’s sweet spot until July, 2024.

Let’s remember, this is inflation that is caused by central bank actions – one of those special situations where fire is used to fight fire. But if so, shouldn’t the measure of success be how well the intentional fire is dampening the original fire? In this case that would be the price path of everything but mortgage interest costs. Seems reasonable.

Number-crunchers would counter that mortgage interest costs are too small to matter (tell that to everyone who’s had to deal with a recent rate reset). True, the 2022 CPI basket weight for mortgage interest was just 3.46%. But multiply that by 30.6% growth, and you add a full percentage point to headline CPI growth. Tuesday’s Statistics Canada report points this out: net of mortgage interest costs, CPI actually rose by just 2.4% – within a hair of the Bank of Canada’s target. By this measure, we could conclude that the inflation battle is almost won.

Sadly, few people see this number; and if they do, they likely find it confusing. What makes sense to them is the headline. And headline growth jumping to 3.3% in July is enough to keep their price expectations well above the Bank of Canada’s 2% zone. The Bank’s stated task is not just to get prices back in line, but to tame those expectations. Many thus reluctantly conclude that more rate hikes are near-inevitable.

If so, there’s a significant risk of overdoing it. Consider the math: given that increases in interest costs won’t be abating anytime soon, if the Bank of Canada wants to nail all-items CPI inflation at 2%, it would have to drive all growth in other consumer costs down to just 0.9%. This path of action virtually guarantees that more broad categories would be in the disinflation or deflation zones. The risk to the economy is that, once the growth in interest costs eventually ebbs, overall price growth would then be well below target – possibly a bigger challenge to deal with than wresting current inflation to reasonable levels.

There’s another possible path. If CPI net of mortgage interest costs were the target measure, the Bank would be satisfied with getting it to 2% growth. If this were achieved, layering in interest costs would lift headline CPI to roughly 3%. It might take some clever messaging to manage expectations and price-setting, but it might well be worth it. The first path risks a considerable loss of economic activity and employment.

Without question, this is a delicate dance. But it’s preliminary at best to conclude that Tuesday’s data forces the Bank of Canada into further tightening. Rate hikes to date will still be biting down hard on the economy well into next year. Spurious and fleeting price changes will doubtless complicate the exercise, but the potion seems to be working. Too much can be lethal.

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