Bank of Canada Governor Tiff Macklem speaks during a press conference at the Bank of Canada in Ottawa on July 12.Sean Kilpatrick/The Canadian Press
If the Bank of Canada just made a major policy pivot, it sure didn’t do much of a job of selling it.
Maybe that’s because the central bank isn’t sold on it itself.
In the bank’s interest-rate decision Wednesday, it announced that it held its policy rate steady at 5 per cent – halting the hikes that it had resumed in June. It then laid out one of the weakest cases you will ever see in support of its decision.
Frankly, if you had skipped the part about holding rates steady, and only read the bank’s analysis of the economy (especially the inflation section), you might have thought the bank had raised rates again. For a stand-pat decision, the accompanying statement had a remarkably hawkish bent.
This is not a statement from a central bank that is striding confidently into a new neutral phase of monetary policy. It feels more like the Bank of Canada had to seriously restrain itself from one more rate hike – and still has its finger hovering over the hiking button as it thinks about its next rate decision in late October.
One day, we may look back on Sept. 6, 2023, as the date when the Bank of Canada ended one of the most aggressive phases of policy tightening in history. But if that proves to be the case, the bank greeted the historic turning point with a nervous, equivocating whimper.
Which, let’s face it, is pretty much what the economic data told it to do. The central bank has talked a lot about letting the data guide its rate decisions. The data since the bank’s mid-July rate increase have said, “Hmmm.”
There’s no trumpeting of the end of elevated inflation, which is the reason the bank went through this jarring rate-hiking exercise in the first place. The annual inflation rate for July was north of 3 per cent, still well above the central bank’s 2-per-cent target. The bank’s favoured measures for core inflation, designed to track the underlying inflationary pressures in the broad economy, are stuck above 3.5 per cent. Year-over-year wage inflation is 5 per cent.
But some recent economic growth numbers suggest that the key source of this troublesome inflationary pressure – excess demand, especially from consumers – has sprung a big leak. The overall economy actually contracted by 0.2 per cent, annualized, in the second quarter. Retail sales, international trade, manufacturing – they’re all fizzling. The job market is slowing. Suddenly, it looks possible that the economy has already entered a recession.
Bank of Canada holds its key interest rate steady at 5%. Here’s what happens next
Those data indicate that the output gap – the difference between supply and demand in the economy, something the bank spends much of its time and energy worrying about – is closing faster than the bank thought, and may be closed already. That has huge implications for the path of interest rates.
And yet, inflation.
So, the bank talked about both, tried not to sound overexcited about the slowing economy, steered very clear of the word “recession,” and stressed that it’s still quite worried about inflation. It stopped its rate hikes, while stressing that it is ready and willing to resume them if necessary.
But while the bank remains tentative, there’s no question that the landscape shifted over the summer. We may have seen the bank’s high interest rates finally rolling over on consumption.
The bank’s last two rate hikes – in June and July – not only pushed the policy rate a half a percentage point higher, to 5 per cent, but did so at the same time as the annual inflation rate retreated, from about 3.5 per cent to around 3 per cent. So, the real interest rate – the rate adjusted for inflation – went from about 1 per cent to about 2 per cent.
That is a very big deal. The Bank of Canada estimates that the “neutral” real rate of interest – where rates neither stimulate nor restrict economic activity – is somewhere between zero and 1 per cent. That means the policy rate needs to be more than one percentage point higher than inflation to pose a meaningful drag on economic activity. Despite all of the Bank of Canada’s rate hikes over the past year and a half, the policy rate only became truly restrictive a few months ago.
It can’t be coincidence that the slowdown has arrived as real rates have crossed into restrictive territory. It’s evidence that rates are working – they are, indeed, high enough to reduce excess demand and, by extension, ease inflationary pressure.
In the summary of the bank’s deliberations leading up to the July rate increase, the bank indicated that the key question facing its policy-setting governing council was whether rates need to be higher to return inflation to target, or whether we just need more time for the effects of high rates to sink in. Much of the economic data since then suggest “more time” might be the answer. But, critically, the inflation numbers haven’t yet spoken on that question.
Until they do, the Bank of Canada won’t be convinced. And based on the wishy-washiness of Wednesday’s announcement, the bank looks quite willing to sound unconvinced. Even, apparently, in its own changes in policy course.