Canada’s economy showed unexpected weakness in the second quarter, recording sluggish readings for both inflation and retail sales.

The consumer price index recorded an annual pace of 2.2 per cent in May, unchanged from April and well below economist expectations for a 2.6 per cent gain, Statistics Canada said Friday. In a separate report, the Ottawa-based agency said retailers recorded a 1.2 per cent sales drop in April, also unexpected.

The reports -- which come on the heels of other disappointing data -- raise questions about the underlying strength of the economy and could cast some doubt about how quickly the Bank of Canada proceeds with future rate hikes.

“The soft patch in Canadian data continued today,” Royce Mendes, an economist at CIBC World Markets, said in a note to investors.

The Canadian dollar fell after the reports, and was down 0.2 per cent to $1.3342 per U.S. dollar at 8:38 a.m. in Toronto trading. Investors pared their expectations for rate hikes this year. Swaps trading suggests a 54 per cent probability of a hike at the Bank of Canada’s next rate decision on July 11, down from about two-thirds earlier in the day. A hike isn’t fully priced in until October, with chances of a second hike by December below 50 per cent.

As recently as last month, more than two more rate hikes had been priced in this year, adding to the three increases the Bank of Canada has already taken.

The “bad data make it even more difficult for the Bank of Canada to hike rates in July,” said Mendes. There is “still time for the data to turn” before the next rate decision with the April GDP release and June employment data due before then, he said.

"This pair of reports certainly does not scream 'July rate hike'. But, given the [Bank of Canada’s] guidance and some special factors that softened these data, a move next month is still in play," BMO Capital Markets director and senior economist Robert Kavcic wrote in a note to clients. 

Randall Bartlett, chief economist with the Institute of Fiscal Studies and Democracy, said he still expects the Bank of Canada to raise rates in July.

“I don’t think anybody should be freaking out at this point in time,” Bartlett said after Statistics Canada released the data. “There is still a lot of momentum in the Canadian economy.”

Inflation Surprise

The inflation numbers were a major surprise given economists were anticipating a sharp pick-up in prices in May on the back of higher gasoline prices. However, a sharp decline in telephone services and cars last month acted as a brake on inflationary pressures coming from higher gas prices, the effects of minimum wage increases and higher mortgage rates.

On the month, consumer prices rose just 0.1 per cent in May, down from a 0.3 per cent gain in April and well below expectations for a 0.4 per cent gain, Statistics Canada reported.

Core measures of inflation -- seen by officials as a better gauge of underlying inflation trends -- posted their lowest readings since January.

Retailers Slump

The weak April retail sales numbers reflected a sharp decrease in car sales. Even excluding autos, the numbers came in below what economists were expecting. Sales excluding car dealers were down 0.1 per cent, versus economist expectations for a 0.5 per cent gain. Retail sales were also down 1.4 per cent once price changes were factored out.

One explanation for the poor retail numbers may have been poor weather, Statistics Canada said.

“Inclement weather in many parts of Canada may have contributed to the overall decline in April,” the agency said in a statement.

Nor are the inflation numbers out of line with the Bank of Canada’s own estimates. Its last forecasts -- released in April projected second quarter inflation to average 2.3 per cent -- and the numbers are currently on track for 2.2 per cent. That’s still a lot higher than what the nation has been able to produce recently, with inflation averaging just 1.4 per cent between 2015 and 2017.

Yet, the recent pattern has been one of weakness across the economy -- which could be a concern. The poor inflation and retail sales data have come on the back of weak manufacturing sales and employment data -- all within the context of growing trade worries.

Other CPI Highlights

• The average of the Bank of Canada’s three key core inflation measures fell to 1.9% in May from 1.97% in April
• The “common” and “median” core rates were unchanged at 1.9%, while the “trim” rate fell to 1.9% from 2.1%
• Inflation for services was unchanged in May at 2.3%. Goods inflation picked up to 2.2%, from 2.1%
• Seasonally adjusted inflation was 0.1% in May, unchanged from a month earlier
• Car prices fell 1.5% in May and telephone services were down 4.3%, acting as the biggest downward contributors during the month

Other Retail Highlights

• Sales were down in 8 of 11 sub-sectors tracked by Statistics Canada
• Ontario (down 2.3%) and Quebec (down 2.7%) were the biggest drivers of the decline in retail sales in April

--With assistance from Erik Hertzberg and files from BNN Bloomberg