If you have a variable rate mortgage, you’ll be very aware of the Bank of Canada (BoC) Prime Rate increases that have happened in quick succession over the last 4 months. The BoC is fighting a battle against inflation driving up prices and wages across the country.  Rocketing inflation was initially started by pandemic supply chain issues causing shortages of goods, then exacerbated by pandemic stimulus packages pumping huge amounts of money into the economy, and finally by Russia invading Ukraine and causing further food and fuel shortages around the world.

The aggressive Prime Rate increases have been worrisome to anyone holding a variable rate mortgage or debt on a line of credit, as the interest rates on these products are based on Prime and so any increases get passed on to consumers through their lenders. Beyond the immediate financial stress of increasing payments, there is also the worry of the unknown – just how high will interest rates go?

Fortunately, we are finally starting to see some signs that inflation is responding to the Prime Rate increases, which means we can be a bit more confident in predicting what is going to happen in the next 12-24 months.

US Inflation Came in Lower for July

In the most recent data released today by the US Labour Department, the consumer-price index (CPI) stayed flat from June through July and on an annualized basis dropped from 9.1% to 8.5%. That’s still a relatively high CPI, but if we have reached the peak of this cycle and are starting on the downward trend into the fall/winter, it’s a good sign that the Prime rate increases implemented by the Federal Reserve are working. The Federal Reserve is still expected to make a few more rate increases over the next 18 months, but a falling CPI will make those fewer and less aggressive.

Canada’s Job Market Has Started Contracting

The latest Statistics Canada numbers indicate the Canadian economy lost 31,000 jobs in July, after losing 43,000 the previous month.

While this is obviously not good news for anyone who has lost their employment, it is an indication for the broader economy that businesses are starting to trim their workforces in anticipation of lower demand for their goods in the coming months.

Since competition to hire employees forces companies to pay more in wages, and these costs get passed on as higher prices, a very tight labour market is a big contributor to inflation.

If we have passed the peak of the labour shortage and we are beginning to transition to a more balanced employment market, this will really help prevent inflation from becoming entrenched through a self-fulfilling wage/price upward spiral.

Preventing such an upward spiral is very important to the Bank of Canada’s fight against inflation, and if this trend continues it will really reduce the pressure on the BoC to make substantial Prime Rate increases in 2023.

Commodity Prices are Starting to Decline

In Canada, the July data shows commodity prices for lumber, copper, oil, wheat (and other crops) have continued to decline, which is a strong sign that investors and businesses are expecting lower demand and/or increased supply in the coming months. Depending on the commodity and the complexity of the supply chain, it can take 3-6 months for the lower commodity price to affect the consumer prices of goods on the shelves, but we’re already seeing lower fuel prices at the pumps and some dropping prices for construction materials.

As long as this trend continues, it will relieve some pressure on residential construction and help the industry continue to build and sell at prices buyers can afford. It should also continue to lower gas prices at the pumps and slow down the escalating food prices at the grocery stores.

Current Predictions for Prime

It still looks very likely that the Bank of Canada will increase Prime by 0.5-0.75% at the next meeting on September 7, 2022. We also expect that there will be an additional rate increase of 0.25% in the winter. However, the sooner inflation shows signs of coming back down in the US and Canada, the sooner the BoC will pause the increases and then turn to decreasing again to fight off a recession.

At the moment, we believe Prime will stay mostly flat through 2023 and that we will start to see a few small decreases in 2024 and 2025 as the BoC responds to try and provide a ‘soft landing’ for the economy once inflation is back on target in the 2% range.

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