Canada’s headline inflation rate fell to a two-year low in May, although the drop was largely due to base-year effects, specifically a significant drop in energy prices compared to a year ago.

The headline consumer price index was up 3.4% in May, down from an annual growth rate of 4.4% in April. The drop was largely influenced by an 18.3% year-over-year drop in gasoline prices. Excluding gasoline, CPI growth was 4.4% compared to 4.9% in April, Statistics Canada noted.

The mortgage interest cost index, on the other hand, remained the largest contributor to the year-over-year CPI increase, with an annual growth rate of 29.9%. Excluding mortgage interest costs, the CPI climbed by a more moderate 2.5% in May, following a 3.7% increase in April.

The Bank of Canada’s preferred measures of core inflation, CPI-trim and CPI-median, both eased in May, slowing to annualized rates of 3.8% and 3.9%, respectively.

“Overall, the breadth of inflation pressures was little changed, still well above pre-pandemic levels,” noted economists from RBC. “Although slowing, underlying inflation trends in Canada are still running well-above the Bank of Canada’s 2% target.”

What it means for the Bank of Canada

Despite the improvements, expectations from markets and economists are that the Bank of Canada is likely to move ahead with an additional quarter-point rate hike at its July 12 rate meeting.

“Bank of Canada policymakers won't breathe a huge sigh of relief after this report as core inflation remains sticky and has yet to show signs of a durable slowdown,” wrote BMO’s Benjamin Reitzes.

“The odds of a July rate hike might be slightly lower now, but if the rest of the data hold up over the next two weeks, a hike still looks likely,” he added.

That would bring the Bank’s overnight target rate to 5%, with prime rate potentially rising to 7.20%.

Markets will also be watching this Friday’s release of GDP data for April and the BoC’s second-quarter Business Outlook Survey.

June inflation data will be released on July 18, 2023.