Bank of Canada holds rate steady, trims growth forecast as inflation risks rise

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The Bank of Canada held its benchmark interest rate steady on Wednesday but left the door open to further increases, as its latest forecast showed a thorny combination of weaker economic growth and more-persistent inflation.

Bank Governor Tiff Macklem and his team kept the policy rate at 5 per cent, the highest level in more than two decades. The decision was widely expected by analysts. It marked the second straight rate announcement in which the bank has remained on the sidelines.

After 10 rate hikes since March, 2022, including two over the summer, higher borrowing costs are having their intended effect. Canadian consumers are pulling back on spending, unemployment is up and economic growth has slowed to a crawl. This means supply and demand in the Canadian economy are “now approaching balance,” the central bank said in its rate announcement – a prerequisite for stabilizing prices.

But the downbeat growth outlook doesn’t mean inflationary pressures have disappeared. The bank increased its near-term forecast for inflation, noting a rise in housing costs and energy prices, as well as a risk that the conflict in Israel and Gaza will escalate and push global oil prices even higher.

Live updates: Bank of Canada holds key interest rate steady at 5%

“We held our policy rate steady today because monetary policy is working to cool the economy and relieve price pressures, and we want to give it time to do its job,” Mr. Macklem said in a news conference after the announcement.

“But further easing in inflation is likely to be slow, and inflationary risks have increased,” he said, adding that the central bank is prepared to raise interest rates again if inflation and other economic indicators aren’t moving in the right direction.

The blend of slower growth and stubborn inflation suggests the Canadian economy is heading for a rough patch. Mr. Macklem said the bank is still not forecasting a recession. But he said the “path to a soft landing,” where inflation returns to the central bank’s 2-per-cent target without a substantial economic contraction or rise in joblessness, “has gotten narrower.”

The bank now expects the annual rate of inflation to average around 3.5 per cent for the next year – higher than its last estimate, which it made in July – before falling back to the 2-per-cent target around the middle of 2025. Consumer Price Index inflation was 3.8 per cent in September, down from a peak of 8.1 per cent in summer 2022.

Meanwhile, the bank cut its economic growth forecast for this year and next year. It now expects gross domestic product to grow 1.2 per cent in 2023, down from the previous estimate of 1.8 per cent. It trimmed its 2024 GDP growth estimate to 0.9 per cent from 1.2 per cent.

This reflects a more abrupt slowdown in the Canadian economy in recent months, weaker foreign demand for exports, and the spike in global bond yields since the summer, which has tightened financial conditions.

“In the battle between slower growth and stickier inflation, the former won out at this meeting,” National Bank of Canada strategists Taylor Schleich, Warren Lovely and Jocelyn Paquet wrote in a note to clients.

“There is clearly some optimism from the Governing Council that rate hikes are working as the economic rebalancing gives them hope more meaningful inflation relief is on the horizon.”

Despite the bank leaving the possibility of more rate hikes on the table and forecasting higher inflation, financial markets upped their bets that interest rates could begin to come down later next year. Yields on two-year Government of Canada bonds fell slightly after the announcement, while the Canadian dollar lost ground, falling to $0.725 against the U.S. dollar, the lowest level since March.

Bay Street analysts widely believe that the Bank of Canada is finished with its historic tightening cycle, although most do not expect interest rate cuts until the second quarter of next year, at the earliest.

During the news conference, senior deputy governor Carolyn Rogers drove home the point that rate cuts are likely a ways off. “The discussion around when we can decrease interest rates has to do with inflation. When we see inflation is sustainably back to target, that’s when we’ll start having a discussion about reducing rates,” she said.

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The bank’s quarterly Monetary Policy Report, published alongside the rate decision, painted a mixed picture of inflation. There are plenty of positive signs. After ticking higher over the summer, headline Consumer Price Index inflation is once again trending lower. There has been a notable slowdown in food inflation, although it remains high. And service price inflation, excluding shelter, is finally cooling alongside a more pronounced slowdown in durable goods prices.

But there are key areas of concern. Annual shelter price inflation was running at 6 per cent in September, and even higher on a three-month basis, squeezing both renters and homeowners.

Much of this is tied to mortgage-interest costs, which have skyrocketed as the central bank has raised rates. More concerning for the Bank of Canada is the fact that the rise in mortgage costs is not being offset by a fall in home prices or a decline in rental costs. And that’s tied to the “structural lack of supply in the Canadian housing market,” Ms. Rogers said.

“Really until we address that supply issue, interest rates on their own are not going to help us get back to a housing affordability situation or solution,” she said.

Worryingly, the bank’s measures of core inflation, which strip out the most volatile price movements, are showing little downward momentum. And wages continue to rise quickly – a welcome development for many workers, but a challenge for the central bank, given how rising business costs can feed into inflation.

Mr. Macklem also flagged geopolitical uncertainty, and the risk that the war between Israel and Gaza could drive up oil prices. “In a more hostile world, energy prices could move sharply higher and supply chains could be disrupted again, pushing inflation up around the world,” he said. The bank is already estimating global oil prices will be around $10 higher over the next two years than in its July forecast. And that’s before any possible energy price shock.

Going forward, Mr. Macklem said, the bank will be paying close attention to core inflation and several other economic signposts. These include measures of excess demand, inflation expectations, wage growth and corporate price-setting behaviour.

“If those things are starting to normalize … we probably won’t have to raise interest rates. But we’ve been very deliberate: We’re leaving the door open to further interest rate increases because there is uncertainty about that, and if we see inflationary pressures persist, we are prepared to raise our interest rate further,” he said.