Is Rising Inflation a Warning That Canadian Mortgage Rates Are On the Way Up?

When Statistics Canada released its latest Consumer Price Index (CPI) report last Friday, it showed that prices have risen by 2% over the most recent twelve months, hitting the Bank of Canada (BoC)’s long-term target for inflation for the first time since April of 2012.

Anyone keeping an eye on where mortgage rates may be headed is well advised to pay attention to the monthly CPI data, which measures the rate at which our average prices are increasing on a year-over-year basis.

The April CPI data beg the question: Are we witnessing the first signs of an uptrend in inflation that will begin to push mortgage rates inexorably higher as so many prognosticators have long been warning? Or is this recent inflation surge just a temporary spike caused by isolated factors?

The answer is important for mortgage borrowers because if inflation is expected to increase more quickly than previously believed, Canadian bond investors will demand higher yields to preserve their expected returns, and this will cause fixed-mortgage rates to rise. If inflation runs above the BoC’s target rate of 2% for an extended period, the Bank would also be expected to raise its overnight rate to increase short-term borrowing costs in an effort to slow the inflation rise, and this would push variable mortgage rates higher.

Let’s take a look at the highlights from the latest CPI data to try to answer this key question:

• Overall inflation jumped by 2% in April after rising by 1.5% in March. So far in 2014, inflation has come in at or above 1.5% in three of the first four months, well above what we have seen over the most recent two years.
• Most of this run up was caused by higher energy prices, which rose by 8.4% in April after increasing by 4.6% in March.
• Within the broader energy category, gasoline prices increased by an average 6.6% over the most recent twelve months and natural gas prices increased by 26% in April, on top of a 17.9% rise in March. The latest surge in natural gas prices was attributed to the Ontario Energy Board’s approval of higher natural gas rates in the province after a long, hard winter, which analysts estimate will add $400 to the average Ontarian’s natural gas bill over the next twelve months.
• While the weaker Loonie continues to have a mild but pervasive impact on price rises because it increases the cost of all of our imports, its effect has been most acutely felt in energy prices. Doug Porter, chief economist at the Bank of Montreal, estimates that the falling Loonie has increased the cost of our oil, both imported and domestically produced (because even our domestic energy is priced in US dollars) by 3% thus far in 2014.

In summary, our recent rise in inflation has been almost entirely fuelled (pun intended) by surging energy prices. Core inflation, a more refined number that strips out more volatile CPI inputs like food and energy, only rose by 1.4% in April on a year-over-year basis – and it remains very much within its average range over the last couple of years.

Interestingly, BoC Governor Poloz warned recently that we would see a spike in inflation caused by higher energy prices but added that he expected the impact to only be transitory, presumably in an attempt to prevent any market overreaction to the most recent data.

So the good news is that the return of our overall inflation rate to the BoC’s target rate of 2% is not being interpreted as a signal that higher mortgage rates are imminent. The bad news is that any prospects of a near-term rate cut by the BoC are now almost certainly off the table (although this always seemed to be a remote prospect anyway, at least from my desk.)

Five-year Government of Canada bond yields rose three basis points last week, closing at 1.57% on Friday. Five-year fixed-rate mortgages are being offered in the 2.84% to 2.99% range and several lenders dropped their rates below 3% last week to enter the spring-market fray, so competition for this business is heating up. Five-year fixed-rate pre-approvals are still offered in the 3.09% range.

Five-year variable-rate mortgages are available in the prime minus 0.65% range, which works out to 2.35% using today’s prime rate of 3.00%.

The Bottom Line: The latest inflation data caught the market’s attention because it marks the first time in two years that overall inflation returned to the BoC’s target rate of 2%, but for the reasons listed above, it has not altered interest-rate expectations. That said, the next BoC Policy Rate announcement is around the corner and I’ll be going over that with my usual fine toothed comb in search of any indications to the contrary.