MNI STATE OF PLAY: BOC Hikes Rate 100BPs, Says More Is Needed

The Bank of Canada raised its key lending rate a more-than-expected 100 basis points to 2.5% Wednesday and said more action is needed with inflation topping 7% this year and remaining above target through most of 2024.

“With the economy clearly in excess demand, inflation high and broadening, and more businesses and consumers expecting high inflation to persist for longer, the Governing Council decided to front-load the path to higher interest rates," policymakers led by Governor Tiff Macklem said in a statement. This increase follows moves of a quarter point in March and half points in April and June.

"Interest rates will need to rise further, and the pace of increases will be guided by the Bank’s ongoing assessment of the economy and inflation," the statement said. "The Governing Council is resolute in its commitment to price stability and will continue to take action as required to achieve the 2% inflation target." Macklem holds a press conference at 11am EST by video conference after recently recovering from Covid.  

Economists almost unanimously predicted a 75bp increase and further signals for more tightening to crack down on the fastest inflation in four decades. While there were no formal predictions of a 100bp hike, BMO, RBC, UBS and JP Morgan said a bigger move couldn’t be ruled out. The hike is the biggest since the full percentage point lift in 1998 in a failed bid to stabilize a weak dollar, and takes the benchmark to the highest since 2008, when it ranged from 2.25% to 4.25%.

ENTRENCHED INFLATION RISK

"More consumers and businesses are expecting inflation to be higher for longer, raising the risk that elevated inflation becomes entrenched in price- and wage-setting. If that occurs, the economic cost of restoring price stability will be higher," the Bank said.

The Bank raised inflation forecasts to 7.2% from 5.3% this year, to 4.6% from 2.8% next year and to 2.3% from 2.1% in 2024. That suggests more doubt the Bank will meet its goal of returning to target within its usual two-year window, with price gains already topping 2% since March of last year. Price gains will slow to about 3% by the end of next year and be "returning to the 2% target by the end of 2024" as global supply chains and energy price gains relax and domestic housing demand cools, the Bank said.

Inflation climbed 7.7% in May from a year ago, the fastest since 1983, and the Bank said it will likely remain around 8% for several months. Wage inflation has also quickened to more than 5% with the unemployment rate at a fresh record low of 4.9%.

The hot job market gives Canada an extra cushion against recession as interest rates rise, though the Bank cut its 2023 growth forecast to 1.8% from 3.2%. The World Bank and BIS have warned about the risk of global stagflation as central banks take needed action to control prices. 

RECESSION SCENARIO

"Activity will slow as global growth moderates and tighter monetary policy works its way through," the Bank said. "This, combined with the resolution of supply disruptions, will bring demand and supply back into balance and alleviate inflationary pressures."

Canada's key rate in real terms fell to record negative lows in recent months as inflation rose faster than the Bank's hikes. Earlier officials had said moving more than 50bps would be unusual but they would be forceful if needed. The word forceful didn't appear in today's statement and neither did any reference to hiking beyond the neutral range the Bank estimates at 2%-3%. 

Canada now has the G7’s highest policy rate and the bigger-than-expected move means it will remain tied with the Fed even if Jerome Powell hikes another 75bps later this month. While upside risks such as a wage-price spiral are more concerning, the Bank's forecast paper said downside risk remains from a bigger-than-expected slowdown in the U.S.

The Bank's forecast also laid out a scenario with a wage-price spiral showing increased risk of recession, laying out a potential contraction over four quarters with a peak quarterly decline of 2.5% at annual rates.