Bank of Canada raises key interest rate to 5%, highest since 2001

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The Bank of Canada increased its benchmark interest rate to 5 per cent on Wednesday, and warned that the downward trend in the rate of inflation could stall over the next year as the economy proves surprisingly resilient to higher borrowing costs.

The quarter-point hike, the second in as many months, brings the policy interest rate to its highest level since April, 2001. The move further increases the cost of borrowing and pushes up debt-servicing charges for Canadian mortgage holders.

The central bank also revised its inflation forecast upward on Wednesday. It now expects the annual rate of consumer price inflation to remain around 3 per cent for the next year, before declining to the bank’s 2-per-cent target by the middle of 2025 – two quarters later than previously forecast.

“With the downward momentum in inflation waning … we are concerned that the progress to price stability could stall, and inflation could even rise again if there are upside surprises,” Bank of Canada Governor Tiff Macklem told reporters, in explaining the bank’s decision to hike again.

Until recently, few economists expected the central bank to still be tightening monetary policy in the summer of 2023. Mr. Macklem and his team paused interest-rate hikes in January, assuming their burst of rate hikes the previous year would be enough to dampen consumer spending and bring inflation back down to the 2-per-cent target.

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Things have not turned out as planned. Overall inflation has fallen sharply, dropping to an annual rate of 3.4 per cent in May from a 40-year high of 8.1 per cent last summer – largely thanks to lower oil prices, which spiked after Russia’s invasion of Ukraine but have since moderated. But “core” measures of inflation, which strip out volatile energy and food prices, have become stuck well above the bank’s target.

Meanwhile, consumer spending has remained strong, employers keep hiring and the housing market has begun to rebound after a sustained slump. This unexpected resilience in the economy has been good for many workers and businesses. But it has become a headache for Canada’s central bankers, who are intentionally trying to slow spending and investment to reduce upward pressure on prices.

Simply put, the stronger the economy, the more likely it is the bank will keep tightening monetary policy – further squeezing mortgage holders, dampening real estate markets and putting strain on the financial system.

Central banks around the world are facing a similar combination of economic resilience and persistent inflation, confounding policy makers and financial markets alike. But there are signs that interest-rate increases are working, albeit slower than many expected. Consumer price inflation in the United States, for example, slowed sharply last month, falling to 3 per cent from 4 per cent in May, the U.S. Bureau of Labor Statistics reported Wednesday.

Mr. Macklem gave no indication of what the Bank of Canada plans to do at its next rate decision, on Sept. 6, but he didn’t rule out further rate hikes. “We are trying to balance the risks of over and undertightening,” he said. “If new information suggests we need to do more, we are prepared to increase our policy rate further. But we don’t want to do more than we have to.”

Bank of Montreal chief economist Doug Porter wrote in a note to clients that Wednesday’s move “can be characterized as a moderately hawkish hike, in that the BoC is certainly not closing the door on the possibility of further moves.”

“While we are not looking for further hikes this year, we are tweaking our rate call in light of the Bank’s view on growth and inflation – we now see rate cuts beginning only in the second quarter of 2024, one quarter later than our prior view,” he wrote.

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Alongside its new inflation forecast, the Bank of Canada also raised its economic growth forecast. It now expects 1.8-per-cent GDP growth in 2023, up from a previous forecast of 1.4 per cent. It expects GDP growth to slow to around 1 per cent in the second half of this year and first half of next year, but predicts the economy will avoid an outright contraction.

“We still think that the increases in interest rates are feeding through to the economy. We still think growth will slow,” Mr. Macklem said. But he added that “there is a path back to price stability while maintaining growth. So there is no recession.”

The bank pointed to several factors behind the surprisingly strong demand in the economy, including high population growth, a tight labour market, accumulated savings, and spending by federal and provincial governments.

“Strong population growth from immigration is adding both demand and supply to the economy: newcomers are helping to ease the shortage of workers while also boosting consumer spending and adding to demand for housing,” the bank said in its rate announcement statement.

Another rate increase means more financial pain for Canadian households, who face higher costs to service their debt.

So far, signs of acute financial strain remain relatively limited, the bank said in a special section of its quarterly monetary policy report, published Wednesday. Delinquency rates for household debt, such as credit card debt and auto loans, are rising, but they remain below prepandemic levels. Meanwhile, mortgage delinquencies are near all-time lows, even for variable-rate mortgage holders, who have been squeezed the most by rising interest rates.

But there are some pockets of concern, the bank said.

“Credit card data show that borrowers are using their credit cards more extensively than they have in the past,” it said. “In addition, although overall delinquency rates on loans remain relatively low, the share of borrowers moving from 60 to 90+ days late on any credit product has risen and is now close to a historical high.”

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Many homeowners have been cushioned against rising rates because their lenders have let them extend the amortization periods of their mortgages rather than increasing their monthly payments. The bank noted that only one-third of mortgage holders have been affected by higher rates so far.

“As this share increases over the coming quarters, more households will face higher debt-service costs. Mortgage holders with variable-rate fixed payments could be particularly exposed,” the bank said.