Bank of Canada Governor Tiff Macklem raised his key lending rate a less-than-expected 50bps Wednesday and said while borrowing costs will keep rising amid the growing risk of entrenched inflation, the drag of past rate hikes is already working in an economy now seen stalling out through the middle of next year.
The overnight lending rate climbed to the highest since 2008 at 3.75% while most economists predicted it would rise to 4%. The statement didn't offer guidance on a terminal rate while saying future moves will be shaped by slowing demand in an overheated economy, improvements in supply chains and inflation expectations.
"The effects of recent policy rate increases by the Bank are becoming evident in interest-sensitive areas of the economy: housing activity has retreated sharply, and spending by households and businesses is softening," Governing Council led by Macklem said in a statement from Ottawa. "The policy interest rate will need to rise further," and "we are resolute in our commitment to restore price stability for Canadians and will continue to take action as required to achieve the 2% inflation target."
The move is another step-down from hikes of 100bps in July and 75bps in September, but whiplashes investors who boosted forecasts to a 75bp hike last week after inflation was a faster-than-expected 6.9% and the Bank's own surveys showed record price expectations. Macklem also used his last several public events to pound home the message that too-high inflation was his top priority even amid signs a recession was coming, a stance criticized by opposition lawmakers.
The decision boosts the argument of economists who say the Bank's terminal rate is around 4.5% and hikes will end over the next several meetings as the economy falters. The Bank's 2023 growth forecast was chopped in half to 0.9% and the 2023 inflation forecast lowered to 4.1% from 4.6% as commodity prices fade, supply chain disruptions unwind and rate hikes slow domestic spending. Policy makers affirmed they remain on track to return inflation to target by the end of 2024 and the Bank's forecast paper noted that while 12-month CPI remains elevated, recent 3-month price gains suggest a budding slowdown.
Policy makers also stepped back from past comments linking the Canadian dollar's 11% slide over the last year to quicker inflation and the need for bigger rate hikes, saying Wednesday the strong U.S. dollar adds to inflation pressure in many countries. Inflation will moderate to the top of the target band of 1% to 3% by the end of 2023, the Bank predicts.
Still, officials also said price gains remain broad-based and there's little evidence core prices are moderating. "Near-term inflation expectations remain high, increasing the risk that elevated inflation becomes entrenched," the bank's decision said. Inflation risks are "roughly balanced" but the upside is more concerning, the Bank's forecast paper said.
Macklem is facing the biggest test of inflation targeting since it was adopted in the early 1990s. The policy rate began the year at 0.25% and the first move of a quarter point in March lagged a run-up of inflation to around 8%, quadruple the Bank’s target. Opposition leaders say bond purchases were too stimulative during Covid lockdowns and policy is now too tight with rate hikes causing unemployment and recession. Prime Minister Justin Trudeau’s Liberals defend the central bank’s independence in a legislature where they rely on the left-leaning NDP to pass confidence votes.
The Bank didn't use the word recession to describe the downturn, declining to join the IMF, several major commercial banks and former Governor Mark Carney who say a mild contraction is likely as interest rates rise and the global economy stumbles. The Bank's Monetary Policy Report said "a couple of quarters with growth slightly below zero is just as likely as a couple of quarters with small positive growth."
Governing Council's statement was more optimistic. "The economy continues to operate in excess demand and labour markets remain tight," they said, and "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."
