Bank of Canada Preview: Tipping Point

Benign core inflation readings likely won’t stop the Bank of Canada from raising rates next week. A host of indicators suggest that the second-round effects of the energy price shock are coming down the pike. Prices for raw materials, industrial products and transportation have remained persistently high. Firms will need to pass along more of those costs in the months to come.

Overall, more than 40% of businesses surveyed by the central bank now see inflation averaging above 3% over the next two years. Such a high reading is more consistent with core inflation running closer to 3% than 2%. Firms are, in part, basing those expectations on how much of the recent cost increases they plan on passing through to consumers. According to that same survey, businesses expect cost passthrough to almost double over the next 12 months.

Consumers’ inflation expectations have also reset higher. Longer-term inflation expectations have risen towards already-elevated short-term expectations of around 4%. Prior to the COVID‑related spike in prices, 5‑year-ahead inflation expectations last hovered near 4% during the Bank of Canada’s 2017–18 hiking cycle.

Central bankers view anchored longer-term inflation expectations as key to keeping price growth near target. With both businesses and households beginning to build in higher inflation expectations, it would be very difficult for Canadian central bankers to keep interest rates unchanged. Monetary policy must be forward-looking, and the Bank of Canada has a single inflation mandate. As a result, unsettling forward-looking measures of price pressures outweigh backward-looking inflation data and have tipped the scales in favour of a rate hike next week.

A closer look at other backward-looking data also suggests the performance of the economy has been better than headlines imply. Despite reported employment declines in August and September, labour market slack has not widened significantly. The size of Canada’s labour force has been stagnant for over a year, with data for the latest two months revealing contractions in the eligible workforce. As a result, the almost 110k fall in employment over the past two months has resulted in just a one-tick increase in the unemployment rate. Surveys also suggest that the labour market is stabilizing and wage growth is firming.

The latest breakdown in trade negotiations with the US is likely to cause a period of economic weakness. But as with past rounds of tariffs, the negative impact on the national economy should be temporary and manageable, as both businesses and consumers find dynamic ways of navigating the challenges. That’s particularly true given the more optimistic outlook for business investment. Changes in government policy and high commodity prices have led to an increase in investment intentions and sentiment among Canadian firms.

Nevertheless, central bankers must be careful not to move too aggressively, with downside risks to the economy very much present. The current situation is clearly more nuanced than the high oil price scenario that the Bank of Canada outlined in its April Monetary Policy Report. That leaves us expecting one further hike in January 2027, after some of the trade-induced near-term weakness passes, rather than the several consecutive hikes that officials outlined as possible in response to their April 2026 high oil price scenario.

While the muted starting point for core inflation isn’t enough to keep central bankers on hold, it does leave more scope for a dovish set of communications to accompany a rate hike. Governor Macklem could both raise rates and guide towards fewer hikes than the four currently embedded in market pricing. Elevated term premia, wider credit spreads and more volatile equity prices suggest Macklem may very well provide a calming message to markets, even as he raises rates to control inflation.