The Canadian Press - ONLINE EDITION

Surprising inflation report triggers talk of sooner than later interest rate hike

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OTTAWA - Canada's annual inflation rate has leap-frogged the Bank of Canada's target for the first time in more than two years, lifting the Canadian dollar to near 93 cents US and boosting speculation about interest rates.

The loonie rose half-a-point early Friday after Statistics Canada reported annual inflation rose three-tenths of a point to 2.3 per cent in May on the strength of higher energy prices and more broadbased price increases.

The report surprised markets and economists alike — and more than likely the central bank — as the headline rate was expected to stay around two per cent.

Core inflation, which discounts temporary volatility in such items as energy, is also proving stubbornly frothy. It too rose three-tenths of a point to 1.7 per cent, nearing the bank's sweet spot.

Analysts said the half-cent jump in the loonie following the morning release of the report was based on the anticipation that Bank of Canada governor Stephen Poloz will need to tone down his warning about the risk of low inflation, and may be forced into considering raising interest rates sooner than expected.

"Not yet, but let's just say a few people are thinking the bank may move earlier than expected," said Douglas Porter, chief economist with BMO Capital Markets.

"It's certainly eased concern about inflation moving below the lower bound and, with that, it's pretty much eliminated the possibility of interest rates moving lower," agreed RBC assistant chief economist Paul Ferley.

Most economists were holding to their forecast of mid-2015 for when rates might be hiked, but a few more inflation reports like this one and that may change.

Central banks regard controlling inflation as key to their mandate, and while the risk of runaway prices seems remote in what is still a slack economy, prices have been rising steadily both in Canada and the U.S. most of this year. In Canada, the annual consumer price index was as low as 0.7 per cent as recently as October.

If the trend continues, Porter said it may test the resolve of both the Bank of Canada and the U.S. Federal Reserve to stick to their beliefs that price pressures remain in check despite five years of low interest rates.

Last week, Poloz took heat from some analysts for maintaining that the recent run-up in the CPI was a temporary phenomenon primarily fuelled by energy costs and that the real danger was a return to too low inflation.

"That ship has sailed," said Porter. While there is little danger of too strong inflation above three per cent, there is also little reason to think the price index will soon drop below one per cent.

May's reading was heavily influenced by a spike in energy prices — 8.4 per cent higher than last year at this time, and for natural gas, 21.3 per cent higher.

But the gains were surprising broad-based as prices increased for all major components, with shelter costs rising by 3.4 per cent, transportation costs 2.7 per cent, and food by 2.3 per cent. Of the major components, alcohol and tobacco led the way with a 3.6 per cent increase.

Influencing the core has been a steady climb in meat prices since January, the agency said. Consumers are paying 10 per cent more for beef than at the start of the year, and 12.2 per cent more for pork.

Despite the increases, there were some bargains to be had in May. Dairy products, digital computing equipment, coffee and tea, cereal products and video equipment were all lower last month than they were a year ago.

Regionally, inflation was highest in Ontario at 2.8 per cent and lowest in British Columbia at 1.5 per cent.

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