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The Bank of Canada held its policy rate at 5 per cent Wednesday – a smart move.

Although the central bank’s governing council may have made its decision ahead of the weak GDP numbers released last week, those numbers underlined the reasons to hold. Real GDP contracted at an annualized rate of 0.2 per cent in the second quarter of 2023 and fell 0.2 per cent month-over-month in June (annualized as well). Looking ahead, Statistics Canada’s advanced estimate for July was flat. The household consumption the bank has been battling finally seems to be flagging. Data on bank deposits and job vacancies also testify to an economy losing steam.

Monetary policy works with a lag, and these latest figures suggest that the painful hikes of the past year and a half are working, slowing economic growth and allowing potential output to catch up.

On their face, high headline inflation numbers make it look like the bank’s job is not finished – which may suggest the bank should have hiked its policy rate again. The bank’s mandate is to hit the 2-per-cent inflation target. From that perspective, headline inflation ticking up from 2.8 per cent in June to 3.3 per cent in July was bad news. The year-over-year core measures also remained stubbornly high, with CPI-trim inflation (which excludes the most volatile items) barely falling from 3.7 per cent to 3.6 per cent between June and July and CPI-median remaining unchanged at 3.7 per cent.

But there is a strong case that inflation is falling faster than the year-over-year numbers reveal.

Bank of Canada holds its key interest rate steady at 5%. Here’s what happens next

A perverse short-run impact of higher interest rates on headline inflation runs through mortgage interest costs. The last Statistics Canada report on inflation showed mortgage interest costs up 30.6 per cent year-over-year, a new record. Although those costs have a weight of less than 4 per cent in the overall consumer price index, stripping them out gives an inflation rate of only 2.4 per cent, not that much above target.

National Bank of Canada, the commercial lender, calculates an inflation measure that strips out energy, food (which has been much higher than overall inflation for some time) and mortgage interest costs. It was 2.3 per cent year-over-year in July and 1.6 per cent (annualized) over the past three months, considerably under target.

Including mortgage interest in the calculation of inflation is problematic for two reasons. One, it is obviously tightly linked to the rise in the central bank’s policy rate – when the bank raises it, in the short run mortgage interest costs on average go up. Two, higher mortgage rates, like higher interest rates generally, reduce demand for credit and slow the growth of money and spending.

The year-over-year increase is also heavily influenced by base effects. The biggest single increase in the bank’s policy rate during this cycle was in July, 2022, from 1.5 per cent to 2.5 per cent. The effect on mortgage interest cost increases was correspondingly large in the early summer of 2022 and has continued since. This year-over-year increase will soon drop out of the calculation of mortgage interest cost inflation and will bring this number down. By pure arithmetic, headline inflation will also come down.

A crude measure of the Bank of Canada’s real interest rate – the policy rate of 5 per cent minus current headline inflation of 3.3 per cent – is 1.7 per cent. This rate exceeds the bank’s own latest estimate of the real neutral interest rate – the rate at which the economy is operating at its potential and inflation is sustainably at 2 per cent. The bank currently estimates this rate to be somewhere between 0 per cent and 1 per cent. That would make the bank’s monetary policy currently quite restrictive – and even more so as inflation decreases. As that 3.3-per-cent headline number continues to fall, the gap with the 5-per-cent target will grow and the real interest rate will increase. In other words, the bank can leave its policy rate where it is and continue to squeeze economic growth, which will bring inflation back down.

With the economy continuing to weaken and inflation moving in the right direction when we probe more deeply, the bank was right to keep its policy rate on hold.

Steve Ambler is a professor of economics at the Université du Québec à Montréal and the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is associate vice-president and director of the Centre on Financial and Monetary Policy.