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Bank of Canada Raises the Policy Rate by 100 Basis Points, Biggest Increase Since 1998

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  • The Bank of Canada increased its target for the overnight rate to 2.5 per cent, with the Bank rate at 2.75 per cent and the deposit rate at 2.5 per cent.
  • The Bank is continuing its policy of quantitative tightening, which started in late April. This means that maturing Government of Canada bonds on the Bank’s balance sheet will no longer be replaced, resulting in the size of the balance sheet declining over time. By July 8th, the Bank’s holdings of Government of Canada bonds had declined from around $425 billion in April to $400 billion.
  • The Bank expects CPI inflation to reach about 8 per cent in the third quarter of this year, easing to 3 per cent by the end of 2023 before returning to the 2 per cent target by the end of 2024. A decline in oil prices and lower houses prices will bring down quarter-over-quarter inflation in the second half of this year.
  • Oil prices are assumed to decline gradually with Brent staying near US$115 per barrel for the third quarter of 2022 and then dropping to US$100 by the end of 2024. Both West Texas Intermediate (WTI) and Western Canadian Select (WCS) will follow similar dynamics.
  • The Bank expects Canada’s economy to grow by 3.5 per cent in 2022, 1.75 per cent in 2023, and 2.5 per cent in 2024. As global growth moderates, economic activity in Canada will slow down. Tightening monetary conditions combined with easing of supply disruptions should alleviate inflationary pressures.
  • The Governing Council decided to “front-load” the path to higher interest rates and increase rates by 100 basis points. In addition, they believe that interest rates will need to rise further given the persistence of inflation and the rate at which the Canadian economy is growing.

Key Insights

If the Bank of Canada does not raise its target inflation rate over the short term, it risks overshooting interest rate hikes and tipping the Canadian economy into a recession. In May, the Consumer Price Index (CPI) inflation rose by an annual rate of 7.7 per cent compared to 6.8 per cent in April. The Bank’s current stance is to bring down inflation to its target rate of 2.0 per cent, a difference of 5.7 percentage points. That is a considerable gap given how rate hikes have already made their impacts felt. After growing by only 0.3 per cent (month-on-month) in April, preliminary estimates show Canadian real GDP declined by 0.2 per cent in May. On the housing side, according to the Canadian Real Estate Association, national home sales fell by 8.6% in May on a month-on-month basis, continuing the downtrend from April. In our latest releases, both the Index of Business Confidence (declined for the fourth straight time) and Index of Consumer Confidence saw declines, signalling concerns over economic outlook. By increasing the target inflation rate, at least in the short term, it allows the Bank to pose a less hawkish stance and asses how rate hikes are impacting the economy. It also gives the Bank time to see how global supply challenges and energy prices, which impact inflation, unfold over the coming months.

Rising interest rates should also be viewed as an extra cost on Canadians, especially those highly indebted. Although the Bank is increasing rates to take control of inflation (which is partly supply driven), it’s doing so at the cost of everyday consumers and businesses. As interest rates rise and pandemic-induced government support programs come to an end, servicing debt will become more expensive. This is especially true for highly indebted households in lower income brackets. In a rising interest rate environment, we expect highly indebted households with limited access to credit to increase their demand for high-interest loans such as payday or installment loans to cover their necessary expenses.

As the Bank of Canada continues its rate hikes, financial markets could continue struggling heading into 2023. By the first week of July, S&P/TSX Composite Index, was down 12.6 per cent year-to-date. Besides a brief uptick in early March, the bond market has also experienced a constant selling-off over the same period. The 10-year Government of Canada benchmark yield increased from 1.4 per cent in early January of this year to 3.2 in the first week of July. Under a scenario of a further inflationary pressures and tightening monetary conditions, we should expect the equity market to continue struggling heading into 2023. If the risk of a recession increases, the bond market could start recovering sooner than expected. With yields surging consistently since the beginning of the year, any indication of a less hawkish stance by the Bank of Canada could fuel demand for the Government of Canada bonds.

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Sasan Fouladirad

Sasan Fouladirad

Economist

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