CPI Progress Paves the Way for September Rate Cut

Overview:

• Inflation dropped to 2.5% YoY, matching our previous market expectations
• Airfare, travel services, core goods and shelter prices were key to CPI deceleration
• The Bank of Canada may cut rates sooner than expected, reaching 4% by October
• We expect USDCAD to move back up despite Canadian developments

Canadian CPI Makes New Progress in July

The July Consumer Price Index (CPI) report brought more positive news on underlying price pressures with headline inflation slowing by 0.2 percentage points to 2.5% year-over-year to match our and market expectations and mark a new post-pandemic low. Prices rose by 0.4% on the month, underpinned by higher gasoline prices (+2.4%) and a seasonal tailwind from travel-related components, although airfares and travel services saw a sharp deceleration on a year-ago basis. Further progress across core inflation measures also lent a dovish tone to the report, with CPI-trim/median slowing by 0.15pp to 2.55% year-over-year on average.

Turning back to the headline print, the progress observed across the more discretionary components of the CPI basket should add to the Bank of Canada's (BoC's) conviction that higher rates are still working to reduce price pressures. Airfares and travel services were key to the deceleration in headline CPI, shaving ~0.13 percentage points from the headline print (despite a combined basket weight of 2.8%). Core goods prices fell by 0.2% month-over-month to hold at -0.5% year-over-year in July, with motor vehicles (-0.7%) and household equipment (-0.3%) contributing to the decline from June.

Shelter Gap a Little Smaller in July CPI Report

Shelter prices were another bright spot in the report with the broader shelter component posting its smallest month-over-month increase since February 2023 as shelter inflation slowed by 0.5pp to 5.7% year-over-year. The deceleration in shelter was underpinned by another muted increase for rents, while mortgage interest costs drove further deceleration for owned accommodation. Meanwhile, the deceleration in travel-related components also brought some relief for core services (excluding shelter) inflation which fell back into the target range with a 0.4 percentage point decline to 2.9% to unwind most of the acceleration from May-June.

Overall, the continued easing across the BoC's preferred measures of core inflation, alongside new signs of progress in shelter prices, should add to the conviction for a return to the 2.0% target, even if three-month rates of CPI-trim/median are not currently showing downward momentum. The 2.55% year-over-year reading for CPI-trim/median marks a new post-pandemic low for the BoC's preferred measures of core inflation, but the report also showed similar progress for CPIX and CPI excluding food/energy.

Change of Call

We have been calling for 100 basis points of BoC cuts in 2024 since the start of the year, and our view had been that 50 basis points increments would ease in (back-to-back 25 basis points) with intermittent pauses to assess their impact on the outlook. However, the new focus on downside risks to the outlook, alongside further progress on underlying price pressures, would argue for a less patient approach. We are changing our call and now look for the BoC to cut another 25 basis points in September and October, reaching 4% by the October meeting, before it steps back to the sidelines in December. We continue to look for another 100 basis points of easing in 2025.

Breadth of Inflation Pressures has Normalized

Market Implications

FX: This report gives BoC the green light to cut more than comfortably in September. We remain bearish CAD vs the USD and JPY and expect USDCAD to move back up in the coming months. Recently, global drivers have mattered more for the CAD crosses than local developments and data. The FX market has been going through a positioning unwind where the once populated long USD trade is now looking much cleaner. Our high frequency fair value model now points to the USD looking cheap on short-term drivers, and we remain cautious of a pullback higher in USDCAD.

Rates: The market got data that helps substantiate what was already priced. We continue to expect CAN-US 10-year rates to move higher toward zero as rates move lower in North America.