The Bank of Canada today decided to raise its overnight policy rate by 50 basis points for the first time since May 2000. In addition to bringing the overnight rate up to 1%, the BoC announced that it would start the process of quantitative tightening on April 25th.
That is, it would cease to reinvest the principal amount of any maturing assets that have been purchased over the past two years under its quantitative easing programme, thus reducing the size of its balance sheet. These announcements came in line with our expectations as well as the broad consensus among sell-side analysts and money markets. With shorter-dated securities making up a significant share of the BoC’s asset holdings, we could see the Bank’s balance sheet decline by roughly 40% over the next two years.
By hiking 50bp today, the Bank hopes it has taken out an insurance policy against rising inflation deanchoring near-term inflation expectations—a dynamic that is likely to cause more persistent above-target inflation and require even higher overall interest rates in the tightening cycle.
The Bank is fully aware that this risk of inflation expectations deanchoring is heavily amplified by rising headline inflation and its judgment that the economy is entering excess demand territory. By acting early and aggressively relative to its previous reaction function, the Bank is hoping to instil confidence in consumers and businesses that monetary policy will actively bring inflation back down to target over the medium term, thus helping keep longer-term inflation expectations anchored to the 2% target. Beyond today’s 50bp hike, language around inflation expectations within the Monetary Policy Report suggests that the BoC will go back-to-back with a second 50bp rate hike on June 1st, bringing the overnight policy rate to 1.5% come the second half of the year. Within the MPR the BoC states that “until inflation moves significantly lower, there is an elevated risk that Canadians will start to believe that it will stay high over the long term,” and as a result, strong inflation pressures could become “embedded”.
In addition to the MPR language, the policy statement used the wording “entrenched,” which was substantially stronger than the tentative “could drift upwards” description of inflation expectations from the last meeting.
The wording in today’s MPR and rate statement solidifies our base case that the BoC will embark on successive 50bp hikes this quarter. The debate will then centre on the effectiveness of this policy decision in anchoring inflation expectations and preventing a hard-to-tame wage-price spiral from forming, which will, in turn, determine the pace of rate hikes and the terminal rate reached this cycle.
In regards to the forward-looking projections contained in the MPR, the Bank of Canada revised down its 2022 global growth estimates by 0.1 percentage points to 3.5%, although the composition was widely different from January’s report. A decline in the biggest advanced economies, i.e. the US, euro area, and Japan, is expected to be offset by gains in China and emerging market economies. US growth was lowered 0.5 percentage points to 2.8% in 2022, and 0.6 percentage points to 1.9% in 2023, largely due to a more pronounced tightening cycle relative to January’s projections. In Canada, growth conditions are forecast to remain robust at 4.2%, a slight increase relative to January’s projection of 4%. However, the upwards revision largely owes itself to the fact that Q1 GDP growth outpaced the Bank’s expectations. The pace of Canada’s expansion is expected to remain high at 3.2% in 2023, down from January’s projection of 3.5%, before settling towards a longer-term rate of 2.2% in 2024. The downgrade in GDP in 2023 is predominantly due to a more restrictive monetary policy stance. On inflation, the BoC has revised its CPI projections 1.1 percentage points higher to 5.3% in 2022 and by 0.5 percentage points to 2.8% in 2023. In Q2, inflation is expected to average 5.8% before moderating to an average rate of 4.5% in Q4.
The BoC’s expectation that inflation will peak in Q2 is further confirmation that now is the right time for the BoC to take an aggressive tightening stance, even if it is purely for a signalling effect.
Beyond GDP and CPI, the Bank also completed its annual re-estimation of potential output and the neutral rate, finding that global and Canadian potential output should strengthen as the recovery from the pandemic continues. That puts the new nominal rate of interest in a range of 2% to 3%, with both endpoints raised 25bps from previous estimates – another sign that the BoC could take a more hawkish stance on tackling inflation than markets currently imply.
Governor Macklem adds little in the press conference, CAD gains extend
While the initial reaction in FX markets and Canadian bonds to today’s BoC decision was relatively muted, the Bank’s decision to hike by 50bps and sound hawkish has helped bond yields remain relatively stable amid a broad G10 bond bid. Falling just 3.5bps on the two-year and 2.7bps on the 10-year, the stability in Canadian bond markets relative to US Treasury yields, which are currently down 8.4bp and 4.7bp respectively, is helping USDCAD drive below the 1.26 handle. However, the performance of the Canadian dollar throughout the press conference is largely a product of broader market pricing as opposed to new information or guidance by Governor Macklem. The most pertinent points made by the Governor are the Bank’s concerns over household indebtedness, which in our view will result in more prudent hiking in H2 2022, and the Bank’s reluctance to begin asset sales as opposed to passive balance sheet roll-off. Both of these points confirm our current base case for the BoC rate path: the Bank will hike 100bp in Q2, before hiking increments revert back to 25bp and further rate hikes are conducted at each MPR meeting, leaving the policy rate at 2% by year-end.
USDCAD breaks 1.26 but the driving factor of the loonie’s rally isn’t just a hawkish BoC, the broad USD dollar also weakened
Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analyst