Printer icon Print Page

How far does the Bank of Canada need to go with its rate hikes?

Craig Alexander
Senior Vice-President and Chief Economist
The Conference Board of Canada

This article originally appeared in the Globe and Mail on September 12.

With last week's interest rate hike, the Bank of Canada has returned the overnight rate to 1 per cent. This decision is infinitely sensible, because it removes the additional monetary stimulus provided in the wake of the commodity price downturn 2 1/2 years ago. The Canadian economy is on track to grow by close to 3 per cent this year, with Alberta likely to top the provincial leaderboard as it rebounds from recession. The pace of growth is rapidly eating up the slack in the economy, as evidenced by a whopping 374,000 net new jobs created over the past year that lowered the unemployment rate to 6.2 per cent in August.

The key question is whether the central bank needs to hike rates further. The Conference Board of Canada believes that continued growth in the economy will eventually warrant further tightening by the end of 2018, but there is no urgency to continue hiking at the next announcement on Oct. 25.

Markets are pricing in a good chance of a further tightening in October. This reflects the strength in the economy, but also the fact that this decision day is accompanied by an updated economic forecast and a press conference that would allow the bank to fully articulate its views. This was why markets were somewhat surprised by the hike last week. Why didn't the bank wait six weeks? Since it chose not to, this might mean another hike is in the offing.

The bank's Sept. 6 communiqué said that the latest policy tightening only reduced, "some of the considerable monetary policy stimulus in place." This is certainly accurate. The long-term neutral level for the overnight rate is around 2.75 per cent. But the bank needs only to reduce stimulus slowly and over a period of years.

The Bank of Canada's objective is to keep inflation between 1 per cent and 3 per cent, with an operational target of 2 per cent. Inflation, as measured by the consumer price index, stood at only 1.2 per cent in July.

However, today matters less to the central bank than what the future holds.

Historically, it takes 12 to 18 months for the full impact of rate hikes to be felt in the economy. But there is a compelling case that inflation risks will remain low.

First, there is still slack in the economy and labour market. The Conference Board of Canada estimates that full employment is consistent with an unemployment rate of 5.6 per cent.

This rate allows for unemployment created by seasonal workers, new entrants looking for work, and the regular churn of jobs in the labour market.

Second, inflation expectations are well anchored, with the vast majority of businesses in the bank's outlook survey anticipating inflation in the 1-per-cent to 2-per-cent range.

Third, although unemployment has fallen over the past year, wage pressures remain weak.

In July, average hourly wages were only keeping pace with inflation. In August, there was welcome news that wage growth increased to 1.7 per cent, but this is still meagre if one expects inflation to eventually return to the Bank of Canada's 2-per-cent target.

The conundrum of tightening labour markets and weak wage growth is not just a Canadian story. In the United States, the unemployment rate has fallen to a level consistent with full employment and yet wage pressures have been surprisingly absent. Perhaps the inflation risks associated with declining unemployment are less than historical relationships suggest.

Fourth, the bank should be mindful of the recent considerable appreciation of the dollar to roughly 82 cents (U.S.). The foreign-exchange rate is providing much less of a competitive boost to Canadian exports and it will reduce the cost of imports, which will temper future inflation risks.

Finally, there is the matter of high household indebtedness and the impact of rising interest rates on real estate activity, which calls for a very measured rebalancing of monetary policy.

The Bank of Canada's past two rate hikes were a vote of confidence in the Canadian economy. The decisions should not, however, be interpreted as the central bank applying brakes to the economy. Since current monetary policy remains stimulative, the right analogy is that the bank is pushing less hard on the gas pedal.

Looking forward, the bank will ultimately need to raise rates further. The issues are timing and degree. The Conference Board's current economic forecast suggests that a further 75 basis points of tightening will be warranted by the end of 2018. But there is no rush, and a gradual, staggered implementation would help the economy to adjust.

For more information contact

Corporate Communications

Monthly Newsletter

Get updates about Conference Board research and events by signing up for our monthly newsletter.

Access Our Research

Access to The Conference Board’s reports is free of charge to professional journalists upon request.

Access Our Experts

We have a team of experienced researchers and economists who are able to comment on current events or share their expertise for news features.

Recent News Releases

Le tabagisme a coûté plus de 16 milliards de dollars à l’économie canadienne en 2012

October 16, 2017

Smoking Costs Canadian Economy More Than $16 Billion In 2012

October 16, 2017

Bryan Benjamin Joins The Conference Board of Canada as Vice-President, Organizational Performance

October 03, 2017

Recent Speeches and Op-Eds

What immigration target should Ottawa set for 2018?

October 05, 2017

Three challenges facing Alberta amid the province’s new economic reality

September 28, 2017

How far does the Bank of Canada need to go with its rate hikes?

September 15, 2017

Connect with Us