Bank of Canada announces interest rate hikes

Key Takeaways:

• Inflation continues to be an issue domestically and abroad.
• Global growth is expected to slow in 2023 but perk up in 2024.
• The bank expects that the policy interest rate will need to rise further.

The Whole Story:

Interest rates in Canada have once again gone up. 

The Bank of Canada announced it has increased its target for the overnight rate to 3.75 per cent, with the bank rate at 4 per cent and the deposit rate at 3.75 per cent. 

During the height of the COVID-19 pandemic, the bank chopped the lending rate to almost nothing but has hiked its benchmark rate six times since March.

Bank officials noted that they also intend to continue their policy of quantitative tightening.

Inflation outside Canada is still high

“Inflation around the world remains high and broadly based,” stated bank officials in their rate hike announcement. “This reflects the strength of the global recovery from the pandemic, a series of global supply disruptions, and elevated commodity prices, particularly for energy, which have been pushed up by Russia’s attack on Ukraine. The strength of the US dollar is adding to inflationary pressures in many countries. Tighter monetary policies aimed at controlling inflation are weighing on economic activity around the world. As economies slow and supply disruptions ease, global inflation is expected to come down.”

Bank officials noted that labour markets in the U.S. remain very tight even as restrictive financial conditions are slowing economic activity. The bank projected no growth in the U.S. economy through most of next year. 

“In the euro area, the economy is forecast to contract in the quarters ahead, largely due to acute energy shortages,” said the bank. “China’s economy appears to have picked up after the recent round of pandemic lockdowns, although ongoing challenges related to its property market will continue to weigh on growth.”

Growth is expected to slow

Overall, the bank projects that global growth will slow from 3 per cent in 2022 to about 1.50 per cent in 2023, and then pick back up to roughly 2.50 per cent in 2024. This is a slower pace of growth than was projected in the Bank’s July Monetary Policy Report (MPR).

“In Canada, the economy continues to operate in excess demand and labour markets remain tight,” noted the bank. “The demand for goods and services is still running ahead of the economy’s ability to supply them, putting upward pressure on domestic inflation. Businesses continue to report widespread labour shortages and, with the full reopening of the economy, strong demand has led to a sharp rise in the price of services.”

Bank officials explained that the effects of recent policy rate increases are becoming evident in interest-sensitive areas of the economy: housing activity has retreated sharply, and spending by households and businesses is softening. Also, the slowdown in international demand is beginning to weigh on exports. Economic growth is expected to stall through the end of this year and the first half of next year as the effects of higher interest rates spread through the economy. The Bank projects GDP growth will slow from 3.25 per cent this year to just under 1 per cent next year and 2 per cent in 2024. 

Higher rates could help rebalance economy

In the last three months, CPI inflation has declined from 8.1 per cent to 6.9 per cent, primarily due to a fall in gasoline prices. However, price pressures remain broadly based, with two-thirds of CPI components increasing more than 5 per cent over the past year. The bank noted that its preferred measures of core inflation are not yet showing meaningful evidence that underlying price pressures are easing. 

“Near-term inflation expectations remain high, increasing the risk that elevated inflation becomes entrenched,” officials said.

The bank expects CPI inflation to ease as higher interest rates help rebalance demand and supply, price pressures from global supply disruptions fade, and the past effects of higher commodity prices dissipate. CPI inflation is projected to move down to about 3 per cent by the end of 2023, and then return to the 2 per cent target by the end of 2024.

“Given elevated inflation and inflation expectations, as well as ongoing demand pressures in the economy, the governing council expects that the policy interest rate will need to rise further,” officials said. “Future rate increases will be influenced by our assessments of how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding. Quantitative tightening is complementing increases in the policy rate. We are resolute in our commitment to restore price stability for Canadians and will continue to take action as required to achieve the 2 per cent inflation target.”

Inflation to worsen before improving

Experts at Avison Young, a global real estate firm, believe inflation is likely to get worse before it gets better and believe more modest rate increases could be on the way.

“The Bank of Canada is leading the charge by global central banks in raising interest rates to tackle inflation and had already aggressively raised rates by 300 bps this year prior to their latest announcement,” said Nick Axford, principal and chief economist at the firm. “The housing market is slowing sharply and growth across the economy as a whole has effectively come to a halt, with a recession now looking likely in the early part of 2023.

Axford explained that despite this, consumer spending remains robust and the labour market is still tight.

“Headline inflation has stabilised for now, but at around 7 per cent this is uncomfortably high – and is likely to rise again before it declines,” he said. “As a result, the Bank continues to focus on preventing a wage-price spiral and remains concerned about the high level of core inflation.” 

Rate hike to restrict credit flow

Axford noted that the rate increase was well above the bank’s estimate of the “neutral” rate of 2-3 per cent.

“This was below consensus expectations of a 75bps rise, given the strength of the latest consumer and retail sales data,” he said. “Looking ahead, we expect rates to be pushed up further, but in more modest increments with one or two 25bps hikes over the coming months. Markets are pricing a peak for rates at just below 4.5 per cent, sensing that the Bank will be reluctant to push beyond this level until they have seen the impact of previous rises.

According to Axford, these impacts likely won’t be broadly felt through the economy for 12 to 18 months. He believes interest rates should stabilise early in 2023 – provided that inflation starts to move sustainably downwards from the early part of next year.

“In the meantime, the latest increase coupled with the quantitative tightening that is also underway represents a significant tightening of financial conditions, which will restrict the flow of credit in the economy,” said Axford. “This will act as a further constraint on the commercial real estate sector and housing market, impacting both pricing and transaction volumes.”