Bank of Canada ends quantitative easing, but an arduous journey lies ahead

• The Bank of Canada held its overnight rate at the effective lower bound of 0.25 per cent. The Bank Rate remained at 0.5 per cent while the deposit rate was also unchanged at 0.25 per cent.
• The Bank has ended its Quantitative Easing (QE) program and is now moving into the reinvestment phase. During this period, the Bank will purchase federal government bonds to replace maturing bonds.
• There was no change to the Bank’s forward guidance. The policy interest rate is likely to remain at its effective lower bound until economic slack is absorbed and the 2.0 per cent inflation target is sustainability achieved. According to the Bank’s latest projections, the first interest rate hike is expected to happen sometime in the middle quarters of 2022.
• The Bank of Canada also revised down its GDP growth forecast. The Bank now expects the economy to grow by 5.1 per cent (6.0 per cent previously) in 2021 and 4.3 per cent (4.6 per cent previously) in 2022.
• The Bank also revised up its inflation forecast. It now expects prices to grow by 3.4 per cent this year and the next. The Bank of Canada previously expected inflation to be 3.0 per cent this year and 2.4 per cent next year.

Key insights:

1. What a time to be a central banker! As expected, the Bank reduced its monetary stimulus. But that was the easy part. A more arduous journey lies ahead. Supply chain disruptions are here to stay at least until the summer of next year. These disruptions are not only fanning inflation but also subduing growth. Moreover, monetary policy isn’t designed to tackle supply chain disruptions which are the primary culprit behind skyrocketing prices. Some would say that the Bank could raise interest rates. While that is true, it also risks putting downward pressure on economic growth.
2. Despite markets pricing in multiple rate hikes next year, we still believe the Bank will wait until the second half of next year to raise rates. This will happen after economic slack has been eliminated, which we estimate will occur in the third quarter of next year, broadly in line with the Bank’s timeline of “the middle quarters of 2022.” The Bank will be walking a tightrope over the coming months. Hike too soon, and you risk stalling growth. Hike too late, and you risk fueling inflation. We believe the Bank would err on the side of caution and wait it out since it’s easier for a central bank to bring down higher prices than to prop up stalling growth.
3. Besides, hiking before the slack is absorbed will also hurt the Bank’s credibility. And given that GDP growth in the last two quarters has been below the Bank’s expectations, it is difficult to make the case that slack would be eliminated in early 2022. The Bank could always drastically revise down its potential GDP to show slack being absorbed early next year, but that too is a difficult case to make.