Bank of Canada Raises Rates Once More As Recession Concerns Grow

• The Bank of Canada increased its target for the overnight rate to 1.5 per cent, with the Bank rate at 1.75 per cent and the deposit rate at 1.5 per cent. This is the second consecutive time that the Bank of Canada has increased rates by 50 basis points. The last time this happened was more than two decades ago.
• 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 to decline over time.
• Driven by higher prices for energy and food, CPI inflation reached 6.8 per cent in April, which was above the Bank’s forecast. It is likely that inflation will move even higher in the near term before beginning to ease. The Bank also believes that the risk of elevated inflation becoming entrenched has risen.
• The Governing Council judges that interest rates will need to rise further given the persistence of inflation and the rate at which the Canadian economy is growing. By raising rates, the Bank increases borrowing costs – which discourages consumer and business spending – in the hope that inflation will ease.

Key Insights

A monetary policy-induced economic slowdown is possible if inflation persists. For now, the probability of a recession happening in the near term remains low, judging by tight labour market conditions, terms of trade (the ratio between the price of exports and imports), and recoveries in sectors severely impacted by the pandemic. Still, if the Bank is hyperfocused on reducing inflation with no immediate success, it risks raising rates more than the Canadian economy can handle. If inflation is partly supply-driven, then monetary policy can only go so far in containing it. In fact, higher rates can deter investments in industries such as food and energy that could have helped with supply challenges.

The housing market could act as a headwind to economic growth. One area where we do see the impact of rising rates is in the housing market. According to the Canadian Real Estate Association (CREA), on a month-to-month basis, home sales in April were 12.6 per cent lower compared to March, while compared to April 2021, sales were down 25.7 per cent. With the Bank expected to continue its rate hikes, buyers (especially first-time homebuyers) could hold off on any home purchases for now until the picture for prices and mortgage rates becomes clear. What tends to follow a sharp drop in demand for housing is a negative wealth effect on homeowners and, ultimately, economic growth.

The Bank of Canada’s credibility is on the line as inflation continues to surge. The Bank believes that based on experience, “maintaining a low and stable inflation environment” is the best way that monetary policy can promote the economic and financial well-being of Canadians. However, if through its primary policy tools, the Bank is not able to bring down inflation to at least its upper target limit of 3 per cent, then both businesses and consumers could start losing confidence in the Bank’s ability to control inflation.