Bank of Canada Governor Tiff Macklem walks outside the central's building in Ottawa.BLAIR GABLE/Reuters
The Bank of Canada has delivered another oversized interest rate hike and signaled that its aggressive campaign to increase borrowing costs isn’t over despite signs that inflation has peaked and the Canadian economy is starting to lose steam.
The central bank raised its policy rate by 0.75 percentage points on Wednesday, increasing the benchmark overnight rate to 3.25 per cent, the highest level since 2008. It said that interest rates need to keep rising to get consumer prices under control.
The move pushes monetary policy into restrictive territory, where borrowing costs weigh on economic growth, for the first time in two decades. Higher rates increase the cost of mortgages, business and personal loans, with the goal of cooling demand for goods and services and acting as a brake on rising prices.
Wednesday’s announcement is another major step in the fastest cycle of rate hikes in a generation. The bank has shifted from near-zero interest rates to a restrictive monetary policy in a little more than six months.
Opinion: Bank of Canada gives hazy glimpse of peak interest rates on the horizon
Governor Tiff Macklem and his team have increased borrowing costs five times since March in response to the highest inflation since the 1980s. That included an increase of a full percentage point in July, and half-point rate hikes in April and June. The bank typically moves in quarter-point increments.
Financial markets and private-sector forecasters say the central bank is nearing the end point, or terminal rate, of its tightening cycle. But the bank gave little indication in the one-page statement that announced Wednesday’s decision of how much further it intends to go.
“Given the outlook for inflation, the Governing Council still judges that the policy interest rate will need to rise further,” the bank said in the statement. “As the effects of tighter monetary policy work through the economy, we will be assessing how much higher interest rates need to go to return inflation to target.”
Beata Caranci, chief economist of Toronto Dominion Bank, said the central bank’s language around future rate hikes suggests it may raise rates several more times.
“They don’t tell you where their landing spot is going to be, and I don’t think they know themselves,” Ms. Caranci said in an interview.
“It’s possible that they go from a 75 basis point hike to 25 basis points in six week’s time,” she said, referring to the central bank’s next rate decision, on Oct. 26. “But I think you would have to see significant movement in inflation expectations and even the economy for them to call it quits at that stage.”
Ms. Caranci and her team increased their terminal rate forecast to 4 per cent after Wednesday’s announcement. Most private-sector economists expect a terminal rate of 3.5 per cent to 4 per cent, although some now suggest the central bank may push the benchmark rate slightly above 4 per cent.
Higher interest rates are already taking a bite out of the economy. After a strong first half of the year, driven by robust consumer spending and the reopening of sectors that pandemic restrictions had closed, GDP growth stalled in the early summer, and may have contracted in July, according to preliminary data from Statistics Canada.
Sectors that are sensitive to interest rates have taken a drubbing, with real estate prices and home sales volumes falling sharply from their peaks earlier this year. Mortgage costs moved up again on Wednesday as Canada’s large banks increased their prime rate in lockstep with the central bank, to 5.45 per cent from 4.7 per cent.
The Bank of Canada acknowledged the softening growth in its rate statement, but noted that “excess demand” continues. That means demand for goods, services and labour is outstripping the capacity to supply them.
“The BoC appears ready to sacrifice more growth than we expected to get inflation falling on a faster trajectory, and we’ll be bumping down our GDP projections for Canada in an updated forecast to be released next week,” Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, wrote in a note to clients.
The central bank is trying to engineer a soft landing, where inflation falls without a recession or a spike in unemployment. Mr. Macklem said in July that he still believes this is possible, although he acknowledged the path to it has narrowed because of the persistence of high inflation.
The bank is wary that Canadians will lose faith in its ability to control inflation, and start setting higher prices and demanding higher wages in a self-reinforcing cycle. The bank warned in its July Monetary Policy Report that interest rates would need to move higher, and cause more economic pain, if this kind of wage-price spiral develops.
“Surveys suggest that short-term inflation expectations remain high. The longer this continues, the greater the risk that elevated inflation becomes entrenched,” the bank said in the rate decision statement.
There are signs that consumer price index inflation is starting to come down. The annual rate of CPI growth dipped to 7.6 per cent in July from a four-decade high of 8.1 per cent in June, largely as a result of falling oil prices.
But getting back to 2 per cent could take years. Even as oil prices retreat and supply chains normalize after the disruption of COVID-19 lockdowns, domestic drivers of inflation tied to the service sector and the labour market are becoming more important.
Measures of core inflation, which strip out the more volatile CPI components such as oil and food, moved higher in July. And while around 74,000 jobs were lost in June and July, the unemployment rate is at a record-low 4.9 per cent and companies are having difficulty finding workers. That’s pushing up wages and feeding into inflation, particularly in the service sector.
“The horse is out of the barn on this one,” said TD’s Ms. Caranci. “We’ve had energy prices, food prices – that goods-side [of the economy] – stay elevated for so long that it’s now bled into the service-side and caused wage expectations to shift. … The challenge is that is going to have some longevity to it.”
The Bank of Canada said in July that it expects inflation to ease to about 3 per cent by the end of 2023 and to return to 2 per cent by the end of 2024.
Canada’s central bank is not alone in its aggressive pivot away from low interest rates. The U.S. Federal Reserve has raised rates four times this year, and forecasters expect another oversized move later this month. The European Central Bank is widely expected to unveil a rate hike of 75 basis points on Thursday.
Central banks were slow to start tightening monetary policy last year and early this year, despite signs that high inflation was not transitory. Many have tried to make up for this mistake over the past six months through an increasingly hawkish approach to inflation fighting.
Senior deputy governor Carolyn Rogers will give a speech on Thursday explaining the rationale for this week’s decision.
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Mark Rendell