MNI INTERVIEW: Pitfalls Seen in BOC Apr Rate Hike- Ex Staffer

The Bank of Canada will wait until July before raising the record low 0.25% interest rate because moving sooner as the market expects would risk undoing a recovery strained by unemployment and consumer debt, former central bank and finance department economist Charles St-Arnaud told MNI.

Rate hikes will also stick to a quarter-point pace rather than accelerated half-point moves mirroring the reductions made as the pandemic took hold, he said. That approach gives policy makers time to assess the drag from consumer debts exceeding 100% of GDP and job growth that will slow as the recovery advances beyond easier early gains.

"We are at this point an extremely leveraged economy," said St-Arnaud, now chief economist at Credit Union Central Alberta. "We are way more sensitive to higher rates than we were 10 years ago, so it's probably better to be more gradual."

Markets are overly aggressive in betting on rate hikes amid a supply shock, he said, noting the likely effects of the 150 bps of increases priced in for next year would be a significant drag on economic growth in 2023. Many Canadian borrowers have also never lived through a cycle of rising interest rates and took out loans chasing million-dollar homes in Vancouver and Toronto, a vulnerability the BOC was watching closely even before the pandemic.

STUCK WITH HIGHER UNEMPLOYMENT?

"The market is not thinking clearly about the consequences of being so aggressive," he said. "The market is very much in the framework that in some ways, central banks will get behind the curve, that inflation that we are seeing right now is becoming permanent."

Governor Tiff Macklem last Wednesday advanced the conditions for a rate increase to between April and September, saying that's now seen as when inflation stabilizes at his 2% target and the economy regains full output. Earlier he saw those conditions in the second half of next year. The BOC said last week the supply squeeze moved the economy closer to full potential, keeping inflation above target longer than expected and creating risks of embedded price pressures.

Macklem is also giving attention to a more inclusive recovery from the pandemic and there has been a rise in longer-term unemployment. While Canada has restored the jobs lost in the downturn, unemployment of 6.9% remains above the 5.6% rate just beforehand, and rate hikes in a supply shock carry a greater risk of hitting the labor market, St-Arnaud said. Markets expect the next job report on Friday to show hiring slowed to 35,000 in October from 157,000 in September, keeping the unemployment rate unchanged.

"What is their tradeoff between accepting inflation" around 3%-4.5% and say "the unemployment rate going back towards 10%?" he said.

FOLLOWING THE GUIDANCE

"It's an important choice for the central bank and they will come under extreme criticism by the public and by the politicians on that," he said. "It's always easier to cut rates or to raise rates when demand is strong, but when it's a supply shock and you create unemployment, it's a harder pill to swallow."

While an April increase can't be ruled out, St-Arnaud said, the pandemic rebuild remains more like a natural disaster than a regular economic cycle for interest rates. "Central banks want to be careful. We are still in the early days of the recovery," he said.

Some investors who already skipped past the BOC's earlier guidance for a move in the second half of next year are already betting on January, underlining the higher stakes in this cycle. "If you don't follow your guidance, you can be viewed as misleading the market," he said. "If (inflation) is not temporary, is there a risk that you overreact."