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Why Rate Cuts Won't Help Canada's Inflation

The breaking news for this week is definitely the surprising inflation rate for the first month of 2024.

Canada’s inflation rate tumbles to 2.9% in January, down from 3.4% in December.

The 2.9% came in as a very pleasant surprise as economists were expecting the rate to be at 3.3%.

Of course, everyone wants to ask the same immediate follow up question.

Can we expect the Bank of Canada to cut rates before June?

We will save that discussion to the end because we first need to decompose the underlying inflation data for the past 4 years before we can have a meaningful discussion on the rate cuts.

Most people spend less these days and we all want rate cut, 

but what is the implication of rate cuts on inflation rate and home prices.

I will show you 3 different scenarios on housing prices if the first rate cut were to happen in March, June or December this year.

A lot of you said you like data analysis episodes, so this will be another episode packed with data, graphs and knowledge.

The latest inflation rate of 2.9% surprised everyone.

But do you know what it is really measuring?

Inflation is calculated based on the price of 8 categories of goods and services and each category carries a different weight in the equation.

The weights of the consumer price index

The biggest item is shelter and it carries a weight of almost 30%.

Next is food, 16.7%.

Transportation, 16.4% and that includes buying a new or used car, as well as gasoline prices.

Furnishings and household operations, 14.36%.

Recreation, education and reading, 9.9%.

Health and personal care, 5%.

Clothing and footwear, 4.7%.

Vice, which includes alcohol, tobacco and cannabis, 4.5%.

We are going to focus on the top 3 items and look at their changes over the past 4 years.

Total CPI inflation and its underlying decomposition

We know that inflation went from around 2% all the way up to 8.1% in June 2022.

Then it started coming down because of all the rate hikes.

Now, it sits at 2.9%, more or less back to the pre-covid level.

Things are going to get interesting when we look at the breakdown.

Here’s the bar for transportation.

See how the bar grew longer and longer post covid because it is basically tracking gasoline prices.

As we have seen a significant drop in gas prices, the bar shrinks to a very small level.

Let’s take a look at food.

It followed a similar trend as transportation, it grew, then shrank.

What about the biggest component, shelter?

It grew, just like transportation and food.

But it did not shrink, it continues to stay high.

You see, things are very clear now.  If we need to reduce inflation further, we must reduce shelter inflation.

So how is shelter inflation calculated?

We know that 28% of the overall inflation comes from shelter.

The 28% can be broken down into 3 components, contributing to 3%, 7% and 18% of the overall inflation.

The 3% comes from water, fuel and electricity.

The 7% comes from rent.  

We have seen double digit rent inflation in major cities and the overall annual rent inflation in Canada is 7.9%.

The biggest component, contributing to 18% of the overall inflation, is owned accommodation.

That includes mortgage interest costs, which has an annual inflation rate of 27.4%.

And homeowner’s replacement costs.

You can think of that as a measure of inflation in home prices.

Because home prices are generally down, the annual inflation for homeowner’s replacement costs is actually negative, it is -1.6%.

Inflation breakdown of owned accommodation

You see, if the interest rate continues to stay high, then mortgage interest costs will continue to stay high.

It is mathematically impossible for inflation to come down much further unless home prices continue to go down.

But it doesn’t look like it is going to be the case based on our analysis last week.

If you missed last week’s video, you can catch it here.

Let’s say the Bank of Canada starts cutting rates, then mortgage interest costs will come down.

Does that mean inflation is going to come down?

Don’t forget this other component, the homeowner’s replacement cost which essentially tracks home prices.

If interest rates come down and home prices go up, then inflation will still be high.

Now that you understand how these 2 components work, I’m going to show you a very interesting graph from the senior economist at TD bank.

It plots the home price inflation.

Home price inflation

From 2023 to 24, we saw negative inflation because prices were coming down.

Now, this graph is going to predict the home price inflation for the next 2 years depending on when the first rate cut is going to happen.

The first scenario is a March rate cut, that’s next month.

The prediction is that home prices will start to go up all the way well into 2025.

The second scenario is a June rate cut, which is the most likely scenario.

Notice how the 2 curves have the same trajectory and they eventually meet near the end of 2025.

The third scenario is a December rate cut.

You see how the trajectory is also the same with the other 2 scenarios, just with a smaller magnitude.

This graph is telling us one important message.

The direction that home prices are going is irrelevant to when the first rate cut happens and shelter inflation is expected to remain high for the next 2 years.

Here’s the thing.

Tweaking the interest rate is not going to solve the shelter inflation problem because there is an underlying supply and demand issue.

In fact, TD bank is urging the Bank of Canada to look past shelter inflation.

If we take out the shelter component from the inflation calculation, guess what our current inflation rate would be?


You see, if interest rates continue to stay high, it is going to hurt our economy.

Meanwhile, it can’t do anything about housing prices.

So keeping the interest rate high is basically just doing more harm than good.

Now that you have learned all the background knowledge, you should be able to understand the highlights from the TD bank paper easily.

I’m going to read out the 4 highlights to you, if you understand them right away and you feel that you gained some valuable knowledge today, please give me a like and subscribe for more knowledge!

Highlight #1 - The Bank of Canada’s inflation problem is mostly a housing issue.  With shelter inflation accounting for more than half of overall inflation, this has become the biggest hurdle preventing the BoC from cutting rates.

Highlight #2 - We map out three scenarios to determine how the BoC could influence the path of shelter inflation based on when it decides to cut rates.  We find that the BoC will have little ability to quickly cool shelter prices, meaning that structurally higher inflation in Canada will persist.

Highlight #3 - This argues for the BoC to start looking past the influence of shelter inflation, as it has under past regimes.

Highlight #4 - For as long as the BoC continues to focus on inflation metrics which are being held up by shelter inflation, Canada will suffer under the weight of high interest rates.


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