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Q&A: How the relationship between rate hikes and inflation plays out

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People shop for produce and seafood at the Granville Island Market in Vancouver, on Wednesday, July 20, 2022. THE CANADIAN PRESS/Darryl Dyck

Statistics Canada said Wednesday that higher mortgage rates are helping fuel the latest high inflation data. But aren’t higher rates supposed to lower inflation?

Mortgage costs have been going up, as interest rate hikes make mortgages more expensive, and they're one of a few components of inflation data directly related to interest rates, explained David Macdonald, senior economist with the Canadian Centre for Policy Alternatives.

In the current environment where interest rates are being hiked at a fast pace, Macdonald said in theory the other components, such as house prices, should be falling faster than mortgage rates are rising.

But that’s not happening, he said. Instead, they’re simply balancing each other out, with mortgage interest costs rising 11.4 per cent over last year, while the index tracking home prices was down 11.1 per cent over last year.

However, rate hikes aren't all about mortgage and housing prices. Macdonald said the long-term expectation is that higher mortgage rates mean people spend less on other things, driving overall inflation down. It just isn't happening yet.

So which parts of inflation are actually affected by rate hikes?

Though rising rates affect some things directly, they also have knock-on effects on other things, such as spending on big-ticket items like cars.

However, the more connected a certain category is to outside or international effects, such as extreme weather or geopolitical turmoil, the less likely they are to be brought down in price by interest rate hikes. Macdonald said food and gas prices, which were up 10.1 per cent and 17.8 per cent over last year in October, are prime examples of this.

Wages are rising too, but not as fast as inflation is. So why do some people think higher wages could make inflation worse, when pay is struggling to keep up?

Given the fact that wages are not rising nearly as quickly as inflation, Macdonald doesn’t think it’s fair to say that wages are driving inflation this time around.

“Workers are taking real pay cuts every month,” he said.

That doesn’t mean wage growth can't be a factor in inflation, but Macdonald said there’s no evidence that wages are the factor driving persistent inflation in this current cycle.

Will the Bank of Canada keep increasing interest rates?

The Bank of Canada has already made clear its plans to further increase rates, though there has been some optimism that the hikes won’t be outsized like the ones seen earlier this year.

But Macdonald said with inflation showing itself to be persistent, the bank is becoming more likely to raise rates by more than a quarter of a percentage point in its next round.

CIBC chief economist Avery Shenfeld said in a note to clients Wednesday that he'd expect to see a half-point hike from the central bank at its December interest rate announcement.

Inflation has been 6.9 per cent for two months in a row now, barely down from previous highs. Should we be worried that it’s sticking around for the long term?

It’s not a question of whether inflation will subside, but rather when and how quickly, said Macdonald.

“It’s absolutely possible to control inflation,” he said, but “it’s increasingly likely that control mechanism will be a recession.”

With every month that high inflation persists, a soft landing becomes less and less likely, said Macdonald.

“The longer we sit at this plateau, the more likely a recession becomes.”

When inflation finally slows down to a more normal rate, will prices go back down too?

Inflation is by definition price growth, so even if the inflation rate slows to, say, three per cent, that doesn’t mean overall prices will fall. Rather, they will rise slower, explained Macdonald. He thinks it’s unlikely Canada will enter a sustained period of deflation, or actual price decreases, which could also trigger a recession.

Of course, prices of specific things can and likely will go down, like gas prices or housing prices, said Macdonald. But sustained higher prices in other categories like food will likely offset those to keep price growth in the positive region.

“The point broadly is that these prices will not come down again.”

This report by The Canadian Press was first published Nov. 16, 2022.

Rosa Saba, The Canadian Press