Canada | Higher inflation is inevitable but likely not sustainable

CPI inflation is set to rise well above the Bank of Canada’s 2% target this spring and will likely surpass 3% y/y for the first time since 2011. But we don’t believe this rise in inflation will be sustained.

Inflation will jump from 0.7% in 2020 to 2.6% in 2021, mainly due to weak base effects from lower prices at the onset of the pandemic, the recent rise in energy prices, and a rebound in demand. However, we expect this rise to prove fleeting and forecast inflation to fall back to 2% in 2022 as these effects dissipate.

However, risks are titled to the upside. Households have built up a stockpile of excess savings over the past year, some of which will be spent as the economy reopens. Combine this with ongoing supply-chain disruptions and historically accommodative monetary and fiscal policy and the case for price acceleration isn’t so farfetched.

There will be pockets of price pressure as the economy reopens this year, particularly for consumer services and durable goods in short supply. But this will reflect a onetime draw down in savings, the release of pent up demand, and realignment of spending patterns, and should therefore prove temporary.

Sharply higher raw material and industrial product prices also represent an upside risk to CPI inflation. While past similar increases in these costs haven’t typically led to a sustained pick-up in consumer price inflation, it’s worth closely monitoring.

In our view, a sustained rise in inflation would need to be driven by either wage growth that is persistently stronger than productivity or a permanent upward shift in inflation expectations. Neither seem likely. Significant slack in labour markets should prevent wage rates from rising in the near term, while structural forces, such as rising labour market participation for older age cohorts and increased automation, should limit upward wage pressures in the long run. Inflation expectations may temporarily drift higher but there is little evidence that a permanent upward shift is underway.

Topics: Economic impact, Canada, Inflation, Coronavirus, Lockdown, Inflation risks