How Energy Shocks Move Inflation (And What Canada's March CPI Says)

Canada's headline inflation jumped to 2.4% in March, up from 1.8% in February. Gasoline prices spiked 21.2% in a single month, the largest monthly increase on record, driven by the Iran conflict pushing oil prices higher globally. But strip out gas, and inflation was only 2.2% year-over-year. Natural gas actually dropped 18.1% for the month because North American supply is more insulated from global price swings.

The question isn't whether energy prices moved inflation. They did. The question is whether the shock stays contained or spreads into the rest of the economy. That's what the Bank of Canada is watching, and it's what matters for anyone trading Canadian equities, the loonie, or energy-related positions.

The core inflation measures, which the Bank of Canada pays close attention to, stayed pretty stable. The median gauge held at 2.3%, and trim eased slightly to 2.2%. Excluding food and energy entirely, inflation actually slowed to 1.9% from 2%. That's the containment scenario playing out so far.

Grocery prices are still climbing though. Up 4.4% year-over-year in March after a 4.1% increase in February. Fresh vegetables jumped 7.8%, the largest increase since August 2023. This isn't just an energy story anymore when food costs are accelerating too.

The two-year Canada bond yield dropped from around 2.8% to 2.76% after the data came out, which tells you the market read this as slightly softer than expected. Economists had projected 2.6% headline inflation, so coming in at 2.4% with core measures holding steady gave fixed income a reason to rally.

The central bank has said it plans to "look through" the short-term oil shock, meaning they're not going to react to a one-month spike in gas prices if the underlying inflation picture stays controlled. They've got their rate announcement next week, and nobody expects them to move from the current 2.25% policy rate.

But traders have already priced in a decent chance of a rate hike later in the year if the energy shock doesn't fade. The problem is timing. If oil prices stay elevated long enough, higher energy costs start bleeding into everything else. Transportation costs go up, so shipping costs go up, so retail prices go up. That's the passthrough effect, and it doesn't happen instantly. It takes months.

Andrew Grantham at CIBC thinks headline inflation could hit around 3% in April if gas prices keep climbing, then ease back slightly in May partly because of the federal fuel tax suspension that kicked in on Monday. Prime Minister Mark Carney paused the fuel excise tax on gasoline, diesel, and jet fuel through September 7th to address cost-of-living concerns. That'll show up in the data eventually, but probably not enough to fully offset another oil spike.

The share of CPI components rising by more than 3% and 5% both dropped in March, which is actually good news. It means the inflation isn't broadening out yet. But "yet" is doing a lot of work in that sentence.

Charles St-Arnaud at Servus Credit Union pointed out the obvious risk: the longer energy prices stay elevated, the more likely those costs get passed to consumers in other categories. Air fares are one of the big ones to watch over the summer. Higher jet fuel costs don't show up immediately in ticket prices because airlines price out bookings months in advance. But closer to summer, if fuel stays expensive, those increases filter into the CPI.

The Canadian economy has enough slack right now that core inflation probably doesn't reaccelerate too much even with some passthrough. But if you're trying to game out what happens next, the setup depends entirely on how long the Iran situation keeps oil elevated. If you're not familiar with how geopolitical shocks translate into market moves, the short version is that markets price in the risk premium fast, but the actual economic impact plays out over months.

The Strait of Hormuz is still a chokepoint for global oil supply. If the conflict escalates or the strait stays closed longer than expected, oil prices don't just spike once and settle. They stay elevated, and that's when inflation expectations start drifting higher. Inflation expectations are a psychological thing, but they matter because if people expect prices to keep rising, they adjust their behavior accordingly, which can make inflation self-fulfilling.

Andrew DiCapua at the Canadian Chamber of Commerce mentioned that exact risk in his note: the longer this drags out, the more it tests Canadians' patience and pushes already elevated inflation expectations higher. That's the scenario where the Bank of Canada has to respond with rate hikes even if they'd rather wait it out.

On the flip side, if oil prices roll over because the conflict de-escalates or OPEC opens the taps to stabilize supply, this whole inflation spike reverses pretty quickly. Energy shocks work both ways.

For anyone trading Canadian assets right now, the setup is pretty straightforward. Headline inflation moves with energy. Core inflation is still contained. The Bank of Canada is on hold next week but watching for spillover into other categories. If you're positioned long Canadian equities or the loonie, you're betting the energy shock stays temporary. If you're hedging or looking at energy-related plays, you're betting it doesn't.

The bond market is pricing in some chance of rate hikes later this year, but not a ton. If core inflation starts creeping up in the next few prints, that probability goes higher, and the short end of the curve adjusts. If it stays contained, the market probably keeps pricing in "higher for longer" at current rates instead of a hiking cycle.

The grocery price acceleration is worth keeping an eye on too. Food inflation doesn't move with energy prices in a clean way, but it does move with consumer psychology and supply chain costs. If Canadians keep seeing 4%+ increases at the grocery store month after month, that feeds into broader inflation expectations even if the central bank's core measures look fine.

Bottom line: this is a classic energy-driven inflation spike so far. Whether it stays that way depends on how long oil prices stay elevated and whether the passthrough into other categories starts showing up in the next few months. The structure right now says contained. The risk is that it doesn't stay that way.