Rate hikes likely despite cool May

May's softer inflation data won't keep the Bank of Canada from raising rates to help cool an economy close to overheating, economists agree.

But with the central bank poised to hike borrowing costs as early as next month, consumers got the welcome news that they can "start working for themselves" as of Wednesday -- four days earlier than last year -- according to the Fraser Institute's annual Tax Freedom Day calculation.

And as bond yields fell this week, many of Canada's major banks lowered their mortgage rates Tuesday for the first time in more than three months. Royal Bank cut its mortgage rates by up to a fifth of a percentage point, effective Wednesday, followed by TD Canada Trust and the Bank of Montreal.

A five-year fixed mortgage is now 7.24 per cent, down from 7.44 per cent, the first major drop in mortgage rates since March and following a hike in rates last week, when bond yields were higher. Financing for mortgages is generally arranged in the bond market.

Earlier Tuesday, Statistics Canada reported that the core annual inflation rate, which excludes volatile items such as energy costs, was 2.2 per cent in May, below analysts' expectations of 2.3 per cent. Overall annual inflation, also known as the headline rate, was 2.2 per cent, matching estimates, on the back of higher gasoline and housing costs.

Overall consumer prices rose 0.4 per cent in May from the previous month, in line with forecasts, from April's 0.5-per-cent gain, Statistics Canada said. Core consumer prices rose 0.3 per cent in May on a monthly basis, from a rate of 0.1 per cent in April, also matching estimates.

The Canadian dollar rebounded from a three-week low on the news and expectations of rate hikes, climbing 74 basis points to close at 94.06 cents US on Tuesday.

While the May inflation numbers were tame, the core rate has been above the Bank of Canada's two-per-cent target for 10 months, riding on low unemployment, record consumer spending and rising energy and housing costs, analysts warned.

"Although some may be tempted to breathe a big sigh of relief, we would caution against popping the champagne corks," said Marc Levesque, chief economics strategist at TD Securities. "All the ingredients are in place to continue to put upward pressure on inflation in the months ahead -- and correspondingly, the risks remain squarely tilted to the upside. . . . We still expect the bank to hike in July."

Douglas Porter of BMO Capital Markets said the Bank of Canada was likely "mildly grateful" for the May reprieve from an economy threatening to overheat.

"While today's result is no great surprise, it breaks a disturbing pattern of stronger-than-expected inflation readings," said Porter. "We continue to expect the Bank of Canada to hike interest rates at the next decision date on July 10, but they are likely to take future rate increases on a case-by-case basis after that point. Our best guess is that they will hike again in September."

With the cost of borrowing going up, Canadians might be relieved to know that, as of Wednesday, they will have paid off the total tax bill imposed on them by government and can start working for themselves, according to the Fraser Institute.

"If you look at the average Canadian family's total tax bill, each and every dollar they earn before June 20 would be required to pay the taxes owing to all levels of government. It takes until June 20 before they begin earning money for themselves," said Niels Veldhuis, the Fraser Institute's director of the centre for tax studies.

The institute calculates Tax Freedom Day as an indicator of the total amount of taxes paid by the average Canadian family to all three levels of government: federal, provincial, and local.

This year, Tax Freedom Day falls four days earlier than in 2006, the institute noted, adding the latest Tax Freedom Day in Canadian history was in 2000, when it fell on June 25.

(prepared by Anne Howland/Vancouver Sun)

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INFLATION WATCH

The inflation rate in May (rise in prices from a year earlier), by province:

British Columbia 1.7%

Alberta 5.0%