MNI BOC WATCH: Surprise 25BP Hike And Assessing If More Needed

The Bank of Canada raised its key lending rate 25bps to 4.75% on Wednesday, the highest since 2001, and signaled it’s prepared to go further with a strong economy threatening to leave inflation stuck well above its 2% target.

“Governing Council will continue to assess the dynamics of core inflation and the outlook for CPI inflation. In particular, we will be evaluating whether the evolution of excess demand, inflation expectations, wage growth and corporate pricing behaviour are consistent with achieving the inflation target. The Bank remains resolute in its commitment to restoring price stability for Canadians,” policymakers led by Governor Tiff Macklem said in a statement.

Governor Macklem's decision continues a pattern of surprising markets, as he did in four of eight meetings last year. Ahead of Wednesday's decision 19 economists surveyed by MNI predicted a hold and five predicted a quarter-point increase. Two of those calling for a hike were from Canada’s five major banks, and most economists called this a close decision and expected a hawkish statement. Today's decision appears more hawkish than many expected, containing a dozen references to surprising strength in areas like services prices and the labor market. Policymakers also said excess demand appears more persistent than thought and noted a global backdrop of stubborn underlying inflation and central bank rate hikes.

"With three-month measures of core inflation running in the 3.5-4% range for several months and excess demand persisting, concerns have increased that CPI inflation could get stuck materially above the 2% target," the Bank's statement said. Inflation is still expected to slow to about 3% in the near term. 

Macklem has ended his rate pause taken in January, a time when the Federal Reserve and ECB were signaling more hikes were needed, though some Fed officials are now signaling they may pause tightening. Canada's tightening comes with the risk of slamming the brakes on an economy some experts predict will fall into recession later this year, and puts more pressure on one of the world’s most stretched housing markets.

The Bank's eight straight hikes through January was the longest series since it moved to fixed meeting dates in 2000 and the benchmark may now be on a path closer to the peak of 5.75% set in 2001, something a generation of home buyers have never faced. The Bank's dramatic 100bp increase last July should also be exerting its peak drag on the economy around now.

The BOC has a single mandate to keep inflation at 2% and it’s now 4.4% after a peak of 8.1% last June. Inflation has exceeded target since March 2021, increasing the danger of sticky price gains. Bank surveys and private polls suggest consumers and firms doubt CPI is returning to target anytime soon. Policymakers have said the inflation run-up is the toughest test of price targets set in the 1990s and have warned in the past they must be more aware of upside risks.

It's not just direct inflation that's too hot. Canada’s economy grew at a 3.1% annualized pace in Q1 – faster than the BOC’s 2.3% prediction -- and perhaps another 1% in Q2 based on a flash April figure. The last jobs report showed wages up 5.2% from a year earlier and unemployment a sliver above record lows at 5%.

Former officials have told MNI disinflation so far is linked to the surge from the Ukraine war and Covid falling out of the 12-month inflation index, and that getting all the way back to 2% is harder. Canada’s real policy rate only recently turned positive against the current rate of CPI and some measures of inflation expectations.

Judging the tightness of Canada’s economy is complicated with the biggest influx of immigrants in decades boosting labor supply and creating more demand, especially in a stretched . Canadians have racked up debts now worth more than the nation's GDP, raising the risk that tighter policy will do more than just cool demand. The IMF last week put Canada at the top of yet another list of risky global housing markets, and sales are gaining steam again since the Bank went on pause.

"Based on the accumulation of evidence, Governing Council decided to increase the policy interest rate, reflecting our view that monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target," the Bank said.