MNI: BOC Tapers QE, Sees 2H'22 Rate Hike As Inflation Heats Up

The Bank of Canada on Wednesday scaled back weekly bond purchases to CAD2 billion from CAD3 billion on more signs of a solid economic rebound and affirmed guidance for raising the record low 0.25% policy interest rate in the second half of next year, keeping it more hawkish than the Fed and ECB.

"We remain committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved. In the Bank's July projection, this happens sometime in the second half of 2022," policy makers said in a statement from Ottawa, which will be followed by a press conference by Governor Tiff Macklem.

While the economy is still expected to use up slack in the second half of next year, the BOC sharply raised its estimates of CPI to 3% from 2.3% for this year, and to 2.4% from 1.9% for 2022. Prices will advance 2.2% in 2023. The Monetary Policy Report also signaled inflation will likely again return to the 2% target in 2024 following swings in gasoline prices and the complex re-opening after Covid-19 shutdowns.

Solid growth starting in the second half of this year the Bank of Canada projects is becoming the dominant story as a clear majority of Canadians have their first dose of Covid-19 vaccine. Policy makers also noted risks from variants of the virus and some weakness in the second quarter during lockdowns, and said a full and inclusive jobs recovery will take time to develop.

INFLATION TESTS TARGET

Tolerance for inflation that's currently the fastest in a long time and projected to average 3.9% this quarter testifies to the unusual economic cycle dictated by the virus. The conditions present the most severe test of the BOC's mandate to restore 2% inflation within two years that dates back to the 1990s. The BOC said slack remains equal to as much as 3% of output and noted the global economy is at risk from an uneven vaccine rollout, even with growth of around 7% this year underpinned by massive U.S. fiscal stimulus.

"Excess demand and resultant increase in inflation to above target are expected to be temporary. They are a consequence of Governing Council's commitment to keep the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved. Inflation is expected to return toward the target in 2024," the BOC's Monetary Policy Report said.

Global and Canadian inflation have been boosted by supply kinks and a run-up in commodity prices while price expectations remain "well anchored," the BOC said. Inflation will remain 3% or more through the rest of this year, fade to about 2% at some point next year on pockets of slack in the economy, then pick up again as the recovery takes hold, the BOC projects.

Total output will be 0.75pp greater at the end of next year than policymakers anticipated in April. The Bank reduced estimated GDP growth this year to 6% from 6.5%, which was more than offset by increasing next year's projected expansion to 4.6% from 3.7%.

Households are expected to cash in some of the record savings built up via government relief programs, boosting consumption growth next year to 3.6% from 2.8%. The BOC also sees housing as a 0.5% drag on the economic growth rate next year and 0.1% in 2023, an unusual view for a market that has exceeded expectations since the middle of the last decade and lately has showed frenzied demand.

END TO QE IN SIGHT

Most economists predicted a taper to CAD2 billion and everyone predicted no change in the target overnight interest rate. The BOC has tapered three times from last year's original CAD5 billion target and the latest move brings into play a phase where the BOC could make final moves to a CAD1 billion goal that would stabilize the size of the balance sheet along with reinvesting maturing assets, or to end QE altogether, a stance that's far ahead of the Fed, ECB and BOJ.

The BOC's economic forecast paper noted that its balance sheet size will become more influenced over time by maturing government bonds, no matter what pace of weekly purchases it sets. The balance sheet has already shrunk to CAD485 billion from the March peak of CAD575 billion as repos lapsed. The BOC now holds 44% of federal government bonds, up from 42% in April.

"Decisions regarding further adjustments to the pace of net bond purchases will be guided by Governing Council's ongoing assessment of the strength and durability of the recovery," the BOC said, echoing previous language.