Over the past two years, Canadians have felt the sting of rising interest rates and high inflation. The Bank of Canada’s short-term policy interest rate jumped from essentially zero in 2021 to 5 per cent by mid-2023, which in turn pushed up market-determined interest rates such as those for mortgages. Meanwhile, inflation climbed from less than 2 per cent in 2020 to an annual average of 6.8 per cent by 2022, well above the Bank of Canada’s target. The inflation surge caught many policymakers and forecasters by surprise.

The sudden return of high inflation and escalating borrowing costs delivered a hard blow to many Canadian households and businesses.

The good news is that inflation has come down significantly in the last year and is now within sight of the Bank of Canada’s 2 per cent goal. In January 2024, the year-over-year increase in the Consumer Price Index (CPI) was 2.9 per cent, down from 3.4 per cent the month before and much lower than the increases in 2022 and most of 2023. It appears the Bank of Canada’s quest to bring inflation to heel has largely succeeded.

But when exactly will the 2 per cent CPI inflation target be reached, and will additional policy measures be required to get there? Recent trends in price changes for various categories of consumer goods and services reveal that inflation has been tamed in many sectors. Gasoline prices, for example, have been falling in tandem with weaker global oil prices, even with the higher carbon taxes that Canadian governments have imposed on fossil fuels. Food price inflation has slowed from close to double-digit rates a year ago to 3.9 per cent in January, with a further deceleration likely in 2024. Year-over-year price inflation has also abated (or in some cases reversed) for cellular services, air travel, home furnishings and appliances, and other goods.

The biggest remaining driver of Canadian inflation is shelter—the cost of mortgages, rents and homeowners’ “replacement costs,” which together comprise 30 per cent of the overall CPI. As of January 2024, shelter inflation stood at 6.2 per cent. According to TD Economics, “high shelter inflation is the single biggest factor preventing the Bank of Canada from achieving the 2 per cent inflation target.”

Unfortunately, shelter inflation isn’t about to disappear, even if interest rates move lower, mainly because population growth is far outstripping the completion of new housing units. Amid record immigration inflows, Canada’s population is expanding by 1.2-1.3 million per year, while housing starts have been stuck below 250,000 and fell in 2023, with another decline in store this year. Given current population growth patterns, Canada must add up to 5 million new homes by 2030 to return to the level of housing affordability that prevailed in the early 2000s. That equates to more than 700,000 housing starts per annum—an impossible goal. So, unless population growth slows, upward pressure on shelter costs will persist.

A second continuing source of inflation is government. Ottawa and several of the provinces have been increasing expenditures at a pace that exceeds both economic and population growth. This policy of enlarging the size of the public sector makes the Bank of Canada’s job of inflation control more difficult, as senior Bank officials have acknowledged. If they practised greater fiscal restraint, our governments would help move inflation back to the 2 per cent target.