Monetary Policy Report—October 2026—In focus
Increases in energy prices affect inflation in two stages. First, they quickly push up fuel prices, raising transportation and domestic production costs. Second, those higher costs gradually pass through to the prices of a broad range of goods and services.
Like the Bank’s previous models, Prima takes into account how demand, supply, inflation expectations and monetary policy affect inflation. However, past models assessed inflation pressures largely by comparing economy‑wide demand with the economy’s capacity to supply goods and services over the medium term.
Prima’s assessment starts with the balance between supply and demand in individual sectors and how this balance affects input costs. The model then projects how quickly cost changes in one sector are passed through to other sectors before finally reaching consumer prices.1
Prima was used to build the outlook in this Report, including to project how the recent rise in energy prices could spread through the economy and affect inflation. This section isolates the impact on inflation from the rise in energy prices since the January Report (Figure 1). It then considers a scenario in which Brent oil prices remain close to US$100 per barrel over the next two years.
Figure 1: How a persistent energy price shock passes through to inflation
Main channels captured in Prima
Prima accounts for the direct effect on prices
Some shocks pass through directly to consumer prices. For instance, the recent rise in energy prices passed quickly into the prices of gasoline, diesel and other fuels (see In focus: Refinery margins and the persistence of energy inflation).
Prima traces how costs move through the production network
In Prima, sectors buy intermediate inputs from one another, and some adjust their prices more frequently than others. As a result, a cost increase in one sector spreads to other sectors gradually and unevenly. It appears first in the prices charged between businesses and only later in the retail prices paid by households.
Energy is a clear example because it is an input for nearly every economic sector. A rise in diesel and jet fuel prices not only increases the costs of transporting goods but also makes it more expensive to produce food, manufacture goods and deliver many services. Rising energy costs abroad also push up the prices of energy-intensive imports, adding to these pressures.
To illustrate, Prima is used to isolate the effects of the rise in energy prices since the start of 2026. At their peak, the effects add around 2 percentage points to inflation in the fourth quarter of 2026 (Chart 29). Most of the initial effect comes from the direct impact on fuel prices. The effect then spreads through supply chains to other major components of the consumer price index, particularly goods excluding food and energy. As oil prices and refinery margins decline, energy prices begin to pull inflation down toward the end of 2027. However, the indirect effects on other components fade more slowly and continue to add to inflation through 2028.2
Prima shows how expected costs affect inflation today
Because most businesses adjust prices only periodically, they base their pricing decisions not only on current costs but also on the costs they expect to face before their next price adjustment. Consider a trucking company that sets its rates once a year. If it expects the rise in fuel costs to last only a few weeks, it may absorb much of the increase rather than risk losing customers. If it expects fuel costs to remain elevated, it is more likely to pass the cost increase on to customers through higher prices.
Prima incorporates this pricing behaviour into its projection and analysis. In the model, businesses eventually pass on permanent cost increases in full. But how much they raise prices right away depends on how long cost pressures are expected to persist and the strength of demand for their products.
Consider a scenario in which oil prices stay around US$100 per barrel and refinery margins remain elevated rather than gradually declining as they do in the base case (Chart 30). In this alternative scenario:
- In the fourth quarter of 2026, energy prices are the same as in the base case, but inflation is 0.1 percentage point higher. This reflects the fact that in Prima, when setting current prices, businesses factor in their expectation that future energy costs will be higher.
- By the third quarter of 2027, inflation is 0.7 percentage points higher than in the base case. This illustrates the sensitivity of the outlook for inflation to the assumption for oil prices.
Prima accounts for demand and trade channels
Prima also traces how the energy shock affects household spending and, eventually, inflation (see Figure 1). For example, rising fuel prices leave some households with less to spend on other goods and services. However, because Canada is a net exporter of oil, higher energy prices improve its terms of trade. These gains boost wealth, supporting spending by other households. Higher oil prices also boost the oil and gas sector’s profits, investment and hiring as well as government revenues.
The energy shock also affects trade. By reducing real incomes abroad, the increase in energy prices weakens foreign demand for Canada’s non‑commodity exports. At the same time, the improvement in Canada’s terms of trade increases demand for the Canadian dollar. The stronger dollar lowers the cost of non‑energy imports but weighs on Canada’s exports by making them relatively more expensive. On net, Canada’s real exports rise by a small amount.
Prima offers a richer analysis of inflation dynamics
Prima strengthens the Bank’s analysis of how shocks such as rising energy prices affect inflation. This helps shape how the Bank explains the inflation outlook.
Endnotes
- 1. See Bank of Canada, “Prima: The Bank of Canada’s model for projection and policy analysis,” (October 1, 2026).[←]
- 2. Other factors supporting CPI inflation relative to the January outlook include higher import prices from a range of sources, Canadian counter-tariffs and the earlier depreciation of the Canadian dollar. The reversal of the earlier cut in the fuel excise tax also temporarily boosts year-over-year inflation in 2027.[←]