The Bank of Canada unexpectedly raised its policy interest rate by a full percentage point to 2.5%, dashing concerns that it would follow the Federal Reserve with only 75bps.
This rate hike, the largest since August 1998, brings the overnight rate directly to the midpoint of its 1 to 3 percent estimate of a long-term neutral rate and sees the Bank of Canada join the Reserve Bank of New Zealand as the first G10 central banks with nominal policy rates firmly at neutral. Owing to the pick-up in inflation pressures and further increases in inflation expectations, the Bank also signalled that subsequent rate hikes are likely. With the Fed expected to conduct two further 75bp hikes in its next two meetings to bring the target Fed funds rate to 3-3.25% by September, the BoC will likely follow up today’s decision with a 75bp hike at its next meeting on September 7th. From thereon in, with rates considered to be above long-run neutral, adjustments are likely to take a more fine-tuned approach as the Bank needs to weigh financial stability and recession risks against its attempt to rebalance demand and supply to abate inflation.
Governor Macklem stated his preference for such a path today when he opened the press conference by stating that the top end of the policy rate is ‘slightly’ above the neutral range.
In response to the BoC’s decision, front-end Canadian bond yields spiked by double digits, but this rally wasn’t necessarily mirrored in longer term rates due to the expected slowdown in growth conditions. Additionally, USDCAD immediately dropped below the 1.30 threshold and currently trades 0.5% lower on the day. The front-loaded nature of the BoC’s hiking cycle should prevent USDCAD from rising too far above the 1.30 handle in the interim even as equities and oil benchmarks tumble, as has been the case thus far this week.
Volatility in USDCAD was relatively muted despite historic 100bp BoC rate hike and hefty US CPI report
The Bank made repeated reference to elevated and broad inflation pressures in justifying its decision to raise rates by a full percentage point today.
Similarly to the Reserve Bank of New Zealand, which also has a policy rate of 2.5% after this morning’s decision, the BoC effectively sees the “path of least regret” as front-loading its hiking cycle to keep inflation expectations pinned and limit the persistence of inflation pressures. It aims to do this by tightening financial conditions enough to weigh on domestic demand and slowly bring it back into equilibrium with supply, which it also expects to be moving lower by 2.5% in Q2 and Q3 due to near-term frictions. Bank staff not only relayed this within the text of the MPR, but also via their economic projections. The BoC now sees real GDP growth at just 3.5% in 2022 and 1.75% in 2023, downward revisions of 0.75pp and 1.5pp from April’s MPR, while they also estimate that the Canadian economy was overheating with an positive output gap of around 0.5-1.5% in Q2–a major contributor to the broadening of inflation pressures.
Another key channel through which today’s interest rate hike will help to lower inflation is by increasing Canada’s interest rate differential with the US.
As we argued previously, this should enable the loonie to effectively buffer any further rounds of broad USD strength, which will limit the pass-through of global demand on Canadian prices. The Bank’s post-mortem suggested that the key reason their inflation forecasts under-shot actual inflation was that they misread the global picture and impact of external price pressures, especially from commodity prices and supply chain constraints. Due to the broadening of inflation drivers and the increasing level of persistence, the BoC now estimates CPI to be 7.2% in 2022, 4.6% in 2023, and 2.3% in 2024. This marks an upwards revision of 2pp, 1.8pp and 0.2pp from April’s forecasts and compounds the case for further monetary tightening for the foreseeable future.
Wage price spiral could see high inflation persist for longer, needing even higher interest rates that could tip the Canadian economy into recession this year
One of the Bank’s risk scenarios made explicit just how terrifying the confluence of rising inflation expectations and rapidly increasing wage pressures have become for Governor Macklem and the Governing Council. The scenario, which lays out a possible outcome should people’s elevated expectations for future price growth become entrenched into their economic planning and bargaining behaviour, creating a well-cemented wage price spiral, shows year-on-year inflation sitting above 8% into 2023, and still being close to double the 2% target by end-2024.
The Bank said that monetary policy would need to be set “much tighter than in the base case” to break the “vicious cycle” of that inflationary dynamic.
Although it only alluded to the magnitude of those interest rates, historical experience has seen the policy rate exceed 20% in the 1980s when a wage-price spiral was in full effect, and Bloomberg’s Taylor rule model indicates that if the Bank of Canada were as aggressive in responding to current conditions as it had in the past, the policy rate would actually be 12.85% right now, more than 5 times the current rate. The impact to economic growth would be far more severe than in the BoC’s soft landing base case, with the risk scenario suggesting the Canadian economy could enter a year-long recession from mid-2022 to mid-2023, and reach a trough of -2.5% quarterly growth after annualisation in Q4 of this year.
BoC slashes Canadian growth expectations, boosts inflation forecasts
Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analyst