Quick take

With Big Inflation Comes a Big Rate Increase

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  • The Bank of Canada increased its target for the overnight rate to 1.0 per cent, with the Bank rate at 1.25 per cent and the deposit rate at 1.0 per cent.
  • The Bank is also ending its reinvestment while starting quantitative tightening (QT) starting April 25. 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.
  • CPI inflation sits at 5.7 per cent (above the Bank’s forecast in its January Monetary Policy Report), driven by rising energy and food prices as well as supply disruptions. The Bank expects CPI inflation to average almost 6.0 per cent in the first half of 2022 and remain above the control range throughout this year. The expectation is for CPI inflation then to ease to roughly 2.5 per cent in the second half of 2023 before returning to the 2.0 target in 2024.
  • Economic growth in Canada is robust and the economy continues to move into excess demand. The Bank expects the Canadian economy to grow by 4.25 per cent this year before slowing to 3.25 per cent in 2023 and 2.25 per cent in 2024.
  • 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.

Key Insights:

  • With rates rising by 50 basis points, it appears that the persistence of inflation was underestimated, leaving the Bank scrambling to raise rates faster than previously expected. The Bank seems to have fallen far behind the curve while inflation expectations continue to climb up. The longer it takes for the Bank to bring down inflation to its 2 per cent target, the higher the chance of workers demanding (even) higher wages and businesses passing on higher costs to consumers (even more). Though it is too soon to witness a wage-price spiral, we are not ruling it out in the coming months. On the other hand, with federal government spending not subsiding anytime soon, it appears that the Bank may have to work even harder to curb inflation expectations.
  • The impact of inflation on the Canadian bond market has not gone unnoticed. Earlier this week, the 10-year Canadian government bond yield touched 2.7 per cent, which is the highest level since December 2013. The 2-year yield has also seen increases, rising to 2.5 per cent this week before easing back down. For now, the threat of inversion between 2-year and 10-year remains low but something to keep an eye on if the Bank is not able to anchor inflation expectations in a timely manner. Given the unparalleled pandemic-induced borrowing and spending by the federal government over the past few years, it remains to be seen if major challenges would arise (especially on longer term Government of Canada bonds) with the rise of yields.
  • Although probably needed to control inflation, the difficulty with a sudden 50 basis point increase today after increasing rates by 25 basis points last month is that it gives little time for the Bank to assess how the increase in rates is impacting the Canadian economy, most notably, the housing market. The problem with continuing to raise rates excessively in a short period of time is that it may not curb overall inflation if supply remains constrained due to supply chain disruptions and Russia’s invasion of Ukraine. Yes, the Bank can cool down the demand side through rate hikes but if the supply side remains constrained, then inflation could very well continue to increase. In addition, a gradual approach to interest hikes could have given the Bank more time to evaluate the price effect of geopolitical tensions and the status of supply chain disruptions. As any improvement in these areas should visibly ease inflationary concerns.

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Sasan Fouladirad

Sasan Fouladirad


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