Inflation unexpectedly surged in Canada, a setback for policymakers as they weigh further interest rate cuts next month.

The consumer price index (CPI) rose 2.9% in May from a year ago, up from 2.7% a month earlier, primarily due to higher prices for services, Statistics Canada reported on Tuesday in Ottawa. That was faster than the median estimate of 2.6% in a Bloomberg survey of economists.

On a monthly basis, the index climbed 0.6%, versus expectations for a 0.3% gain and up from 0.5% in April. On a seasonally adjusted basis, inflation rose 0.3%.

The Bank of Canada’s (BOC) two core inflation measures also accelerated, averaging a 2.85% yearly pace - faster than economists expected. 

Tuesday’s data broke a four-month string of easing price pressures. The reacceleration of both headline and core inflation will likely caution the central bank against a second consecutive interest rate cut next month, as officials seek to understand whether the latest setback is temporary.

“The inflation path remains uneven, which means the rate cut path likely won’t be smooth either,” Benjamin Reitzes, rates and macro strategist at Bank of Montreal, said by email. “While we won’t rule out a July cut, the odds just fell notably.”

The Canadian dollar jumped on the release but pared some gains to trade at C$1.3647 per US dollar as of 9.24am Ottawa time. The yield on two-year Canada bonds rose about nine basis points (bps) on the day to 4%. 

Governor Tiff Macklem and his officials lowered the benchmark overnight rate by 25bps to 4.75% earlier this month, the first Group of Seven central bank to kick off an easing cycle. After seeing several months of cooling price pressures, they said they were more confident inflation was headed to the 2% target and that monetary policy no longer needed to be as restrictive.

Tuesday’s inflation release is the first of two such reports before the next Bank of Canada rate decision on July 24. The majority of economists in a Bloomberg survey expect policymakers to hold borrowing costs steady at that meeting before easing again at the next meeting in September.

“The lack of progress in May reduces the likelihood that the Bank of Canada will cut in July. But with another CPI release before the July decision, the door is not completely closed,” Charles St-Arnaud, chief economist at Alberta Central, said in an email.

Macklem reiterated on Monday that it’s reasonable to expect further reductions in the policy interest rate if price pressures continue to ease. But officials don’t want to lower rates too quickly and jeopardize progress on inflation.

A three-month moving average of the inflation rate rose to an annualised pace of 2.52%, from 1.64% in April, according to Bloomberg calculations.

In May, mortgage interest costs and rent remained the biggest contributors to the annual change in the rate of inflation. Mortgage interest costs jumped 23.3% and rent rose 8.9% on a yearly basis. Excluding shelter costs, the consumer price index rose 1.5% from a year ago, versus 1.2% in April.

Excluding food and energy, the index rose 2.9% from a year ago, up from 2.7%. Services inflation was up 4.6%, compared with 4.2% in April.

Food prices rose 2.4%, versus 2.3% in April. Groceries increased 1.5% from a year ago, the first acceleration since June 2023, and rose 1.1% from the previous month - the biggest monthly gain since early last year.

Regionally, prices increased at a faster pace from a year ago compared with April in six of 10 Canadian provinces, including Ontario and Quebec.

The release incorporates new basket weights from Statistics Canada, but they didn’t impact the headline yearly CPI change, the agency’s analysts said.

"Reaccelerating inflation argues for the BoC cutting rates only slowly. One poor inflation report isn’t a trend, but we think the BOC will remain on hold at the July 24 meeting. With upside risks to inflation coming from home prices - which could rise as interest rates fall - and with only limited room to diverge from the Fed, we think the BoC will cut its overnight-rate target at just a quarterly cadence," said Bloomberg Economics economist Stuart Paul.

  - Bloomberg