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April 26, 2022

Bank of Canada faces ‘delicate balance’ as it raises rates, Macklem says

The Bank of Canada faces a “delicate balance” as it tries to bring inflation back down without slowing the economy too much and triggering a recession, Governor Tiff Macklem said on Monday.

The Canadian economy is in a relatively good position to handle rising interest rates, Mr. Macklem said in an appearance before the federal finance committee. But he acknowledged that pushing the cost of borrowing sharply higher to try to quell rising consumer prices has some risks, particularly given the high level of household debt in Canada.

“Getting this soft landing is not going to be easy,” Mr. Macklem said, although he added that there are “some good reasons” to believe the economy will continue to grow as consumer prices decline.

The point of higher interest rates is to tamp down demand in the Canadian economy to bring it back in line with the country’s supply capacity. But raising rates too fast and too high could trigger a housing market correction, choke off business investment and erode consumer confidence.

The Bank of Canada is in the early stages of an aggressive campaign to bring borrowing costs back up to normal levels after holding them at record lows for much of the pandemic. Two weeks ago, the bank’s governing council raised the benchmark policy rate by 50 basis points to 1 per cent – the first oversized increase in two decades. It usually moves in quarter-point increments.

Mr. Macklem said on Monday that the governing council will likely consider another hike of 50 basis points for the June 1 rate decision. He said an even larger increase was possible, although such a move would be “very unusual,” and reiterated that the bank intends to get its policy rate back up to between 2 and 3 per cent relatively quickly.

Robert Hogue, assistant chief economist at Royal Bank of Canada, said the possibility of a housing market correction “is not a big stretch,” given how much real estate prices have increased over the past two years.

“The kind of [interest rate] increases that we’re contemplating and the market is now pricing in … would constitute a fairly significant change for the market to adjust to and to absorb,” Mr. Hogue said in an interview.

“As central bankers, they have to be mindful of not just triggering a correction, but something that’s deeper, and could be destabilizing.”

Mr. Macklem told the finance committee there are several reasons to believe the Canadian economy will be able to continue growing over the coming years while also bringing inflation down. Many of the factors driving inflation – which hit an annual rate of 6.7 per cent in March – are the result of global supply chain disruptions caused by the COVID-19 pandemic and spikes in commodity prices resulting from Russia’s invasion of Ukraine.

“If oil prices stop going up … and these global supply chain pressures begin to abate, we should see some natural reduction in inflation provided we keep inflation expectations well anchored,” Mr. Macklem said.

He also suggested that there’s room to cool the overheated job market without too many people actually losing their jobs. Right now, the country has a huge number of job vacancies; Statistics Canada said employers were actively recruiting for more than 800,000 vacant positions in January.

“I won’t pretend it isn’t delicate,” Mr. Macklem said. “But with an economy that is in excess demand with a labour market that’s got very high levels of vacancies, if we can get this right, we can reduce those vacancies, keep strong employment and get inflation back to target.

“That’s our aim. Are there some risks? Yes, there are some risks.”

Mr. Macklem and his team are hoping that Canadian consumers will do much of the heavy lifting to keep the economy out of recession even as monetary policy gets tighter. Household balance sheets are in relatively good shape, with many Canadians having built up savings over the past two years. The Bank of Canada estimates that Canadian households have built up around $200-billion in “excess savings,” compared with what they would have saved before the pandemic, which could support robust consumer spending even in the face of higher interest rates.

At the same time, Mr. Macklem acknowledged that the Bank of Canada does not have a good line of sight into global supply problems, which makes economic forecasting extremely difficult.

And he admitted the bank was wrong on a number of things over the past year.

“We got a lot of things right, we got some things wrong. We are responding,” Mr. Macklem said.

Mr. Hogue of RBC said his base case for the next two years does not include a recession. That said, the longer inflation remains elevated, the higher the risk that the Bank of Canada will need to raise rates to punishing levels.

“If the inflation rate over the next few months starts to come down, then maybe the risk might start to shift. But right now, things don’t look necessarily good, especially after the March [inflation] numbers that caught more or less everybody by surprise. … It does raise a higher risk of a harder landing at large in the economy,” Mr. Hogue said.

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