The Bank of Canada is ending its quantitative easing program and moving forward its timeline for potential interest rate hikes as supply chain disruptions and surging oil prices have forced it to reconsider its outlook for inflation.
The central bank kept its policy interest rate at 0.25 per cent on Wednesday, but said that it could start raising the benchmark rate in the “middle quarters of 2022,” opening up the possibility of a rate hike as early as April. Previously, the bank said it wouldn’t hike rates before the second half of 2022.
It also announced the end of its quantitative easing (QE) program, a measure launched at the start of the COVID-19 pandemic that has seen the bank buy hundreds of billions of dollars worth of federal government bonds and quadruple the size of its balance sheet in an effort to hold down interest rates.
The changes put the Bank of Canada ahead of most major central banks in withdrawing stimulus put in place to support the economy through the pandemic. Central banks around the world are struggling with a surge in inflation caused by a spike in energy prices, transportation bottlenecks and shortages of manufacturing inputs, such as semiconductors. The strength and persistence of consumer price growth in recent months has caught monetary authorities by surprise, forcing some to revise their economic projections and begin tightening monetary policy.
“We will be considering raising interest rates sooner than we previously thought,” Bank Governor Tiff Macklem said in a Wednesday morning news conference. “Interest rates don’t need to be as low for as long to get that full recovery and get inflation back.”
The pace of annual consumer price index growth has been above the central bank’s 1-per-cent-to-3-per-cent target range since April, hitting an 18-year high of 4.4 per cent in September.
In its quarterly Monetary Policy Report (MPR), published Wednesday, the bank increased its inflation projections. It now expects inflation to average around 4.8 per cent for the remainder of 2021 before gradually dropping to around 2 per cent by the end of next year. It raised its inflation outlook for the whole of next year by a full percentage point, to 3.4 per cent from 2.4 per cent.
These revisions will feed into the continuing debate about whether current high inflation is “transitory,” or whether it is the start of a period of longer-lasting price pressures. Mr. Macklem repeated the bank’s long-held view that the jump in consumer prices is being driven mainly by temporary factors, including gummed-up transportation networks and a spike in the price of oil, which reached US$85 for a barrel of West Texas intermediate crude this week. But he acknowledged that supply bottlenecks are “more severe and more persistent,” than the bank expected.
Mr. Macklem said the bank is watching wage growth and inflation expectations closely to see if supply-side price pressures feed into more generalized inflation and become entrenched. “So far we’re not seeing that. But if we do see that, we will certainly take action and adjust our monetary policy stance further,” he said.
The market response to the announcement was swift. The Canadian dollar increased by about half a cent, while the yield on two-year Government of Canada bonds jumped around 20 basis points on Wednesday. (A basis point is one one-100th of a per cent).
Global supply chain problems – illustrated most vividly by fleets of container ships anchored off ports in California waiting to unload – are not only pushing up prices, they’re also weighing on economic activity in Canada. While the bank expects demand in the economy to be supported by strong consumer spending, business investment and a rebound in exports, supply-side issues will remain a drag. The shortage of semiconductors, for example, is slowing automobile production, and taking a major bite out of Canadian exports.
The bank now expects the Canadian economy to grow 5.1 per cent in 2021, down from the previous projection of 6 per cent. It lowered its 2022 GDP growth projection to 4.3 per cent from 4.6 per cent, although it raised its 2023 projection to 3.7 per cent from 3.3 per cent.
The bank also lowered its projection for potential output growth over the next two years to 1.6 per cent from 1.8 per cent, a move that has significant implications for monetary policy. Lower potential growth means the “output gap” – the difference between what the economy can produce and what it is producing – will close sooner than the bank previously expected. This is a key factor pulling forward the bank’s projection for interest rate hikes from the second half of 2022 to the middle quarters of next year, as it has promised not to raise rates until slack in the economy has been absorbed.
Bank of Montreal chief economist Douglas Porter said he expects the central bank to start raising rates in the middle of next year. “We would assume that rate hikes progress quarterly until late 2023, bringing the overnight rate back in line with pre-pandemic levels two years hence,” he wrote in a note to clients.
“With employment back to pre-pandemic levels, housing prices still raging, equities at an all-time high, and inflation at almost a two-decade high, the bank’s sudden hawkish shift seems entirely appropriate,” he added.
The labour market has improved greatly in recent months, with Canada adding around 157,000 jobs in September, bringing the number of people employed back to prepandemic levels. The central bank noted in its MPR that “groups that suffered the greatest job losses – women and youth – have experienced an almost complete recovery in recent months.”
Nonetheless, the job market recovery is incomplete. Hours worked remain below prepandemic levels and long-term unemployment remains elevated, while businesses are reporting difficulty finding workers. And Canada is entering a period of labour market uncertainty, as a number of federal government support programs come to an end, including the Canada Recovery Benefit and wage support programs.
The continuing slack in the economy led the bank’s governing council to conclude this week that “considerable monetary policy support” was still necessary. Even so, the choice to end the QE program and pull forward the timeline for a potential interest rate hike is a major step in the direction of tightening monetary policy.
The end of QE marks the beginning of what the bank calls a “reinvestment phase,” where it will keep the size of its balance sheet steady by purchasing only enough assets to replace existing holdings as they mature. It currently owns around $425-billion worth of federal government bonds, most of which it acquired over the past year and a half. Going forward, the bank expects to buy between $4-billion and $5-billion worth of government bonds each month, down from a peak of $5-billion every week earlier in the pandemic.
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