Bank of Canada delivers quarter-point rate hike, signals pause to further increases
The Bank of Canada increased its benchmark interest rate by a quarter of a percentage point, but said that it expects to hold off further rate hikes, making it the first major central bankto say it would pause monetary policy tightening.
This is the eighth consecutive rate increase, and brings the bank’s policy rate to 4.5 per cent.
“We have raised rates rapidly, and now it’s time to pause and assess whether monetary policy is sufficiently restrictive to bring inflation back to the 2-per-cent target,” Bank of Canada Governor Tiff Macklem said in a news conference.
“To be clear, this is a conditional pause,” Mr. Macklem added. “If we need to do more to get inflation to the 2-per-cent target, we will.”
The bank lowered its forecast for inflation on Wednesday. It also reiterated that it expects the economy to “stall” in the first half of the year, but does not foresee a significant recession.
The widely expected decision marks a turning point for the central bank. Over the past year, it has pushed Canadian borrowing costs rapidly higher to combat runaway inflation. Now, with price pressures easing and the economy slowing, the bank has said that interest rates are likely as high as they need to go.
The bank now expects consumer price index inflation to fall to about 3 per cent by the middle of this year, and to 2.6 per cent by the fourth quarter. It sees inflation returning to the 2-per-cent target in 2024.
The annual rate of inflation remains well above those levels, clocking at 6.3 per cent in December. But that is down from a peak of 8.1 per cent in June. Price pressures continue to ease thanks to a drop in oil prices and improvements in global supply chains, plus the slowing effects on the economy of the bank’s rate increases.
The average price of gasoline, for instance, has fallen from about $2 a litre last summer to about $1.50 in January, the bank noted in its quarterly Monetary Policy Report (MPR), published Wednesday.
“While the Bank did not rule out future rate hikes entirely, the new guidance reinforces our view that the Bank’s next move is likely to be a rate cut, albeit not until later this year,” Stephen Brown, senior Canada economist at Capital Economics wrote in a note to clients.
The expected drop in inflation comes alongside a slowdown in the Canadian economy. The bank expects growth to flatline through the first half of 2023, as higher borrowing costs squeeze Canadians’ finances and weigh on consumer spending and business investment.
“It’s just as likely that we’ll have two- or three-quarters of slightly negative growth as slightly positive growth,” Mr. Macklem said. “So yes, it could be a mild recession. It’s not a major contraction.”
“We do need this period though of essentially no growth to allow supply to catch up,” he added. “But I don’t want to pretend that it’s painless. It’s not painless.”
So far, the Canadian economy has proven more resilient than expected. Unemployment is near a record low and consumer spending has remained relatively robust. But there is “growing evidence that restrictive monetary policy is slowing activity,” the bank said.
Higher interest rates hammered the housing market in 2022, and consumers have begun to cut spending on big-ticket items. The bank expects spending to slow further as homeowners renew their mortgages at higher interest rates and nervous shoppers trim non-essential purchases.
“The rise in borrowing costs is expected to continue to strain many household budgets. Interest payments on household mortgages are estimated to be about 4.5 per cent of disposable income at the beginning of 2023, up from 3.2 per cent at the beginning of 2022,” the bank said in the MPR.
The bank is intentionally using interest rates to slow the economy and inflation. The goal is reducing spending on goods and services to bring overall demand in line with supply, which eases price pressures.
The bank says that the economy remains in a position of “excess demand.” This is most visible in the labour market, where unemployment is low and businesses continue having trouble finding enough workers. This is fuelling wage growth and feeding through into inflation, particularly in the service sector.
The bank has argued that unemployment will need to rise to get inflation back to target.
“With the pace of wage growth no longer increasing, the risk of a wage-price spiral has declined. However, unless a surprisingly strong pickup in productivity growth occurs, sustained 4 per cent to 5 per cent wage growth is not consistent with achieving the 2 per cent inflation target,” the bank said.
There are other risks to the inflation outlook, the bank said. Service prices could prove “stickier” than expected. Oil prices could also rise more than anticipated, depending on what happens with the war in Ukraine and China’s reopening from COVID-19 lockdowns.