Almost exactly one year ago, the Bank of Canada embarked on its most aggressive rate-hike campaign in a generation. That drive to raise borrowing costs will likely grind to a halt on Wednesday, with the central bank widely expected to hold its benchmark interest rate steady, rather than increasing it, for the first time in 12 months.
After eight consecutive rate increases, central bank officials believe they’ve done enough to get inflation back under control. The pace of consumer price growth remains well above the bank’s target. But there are increasing, if conflicted, signs that higher borrowing costs are having their intended effect: slowing the economy and weighing on price growth.
In January, Bank of Canada Governor Tiff Macklem announced a “conditional pause” to further rate hikes, teeing up the March 8 rate decision as a turning point for monetary policy.
Mr. Macklem did not rule out further rate hikes if the economy holds up better, and inflation proves stickier, than the bank is forecasting. But most analysts believe that weaker-than-expected GDP growth in the fourth quarter of 2022 and a larger-than-expected drop in inflation in January should give the bank confidence to stand pat this week, holding its overnight rate at 4.5 per cent.
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“While this Governing Council has shown little concern about crossing markets in the past, it’s not going to dump its conditional pause before the first gate,” Bank of Montreal chief economist Doug Porter wrote in a note to clients.
A pause this week would make the Bank of Canada the first major central bank to stop increasing interest rates. That would put it on a different trajectory than the U.S Federal Reserve, whose officials expect to raise rates several more times.
Interest rate changes work with a lag, squeezing consumer spending as homeowners renew mortgages at higher rates, and pushing up unemployment as businesses see a drop in demand. This delayed reaction raises mirror-image risks: that the central bank does too little and lets inflation re-accelerate; and that it does too much and pushes the economy into an unnecessarily painful contraction.
“The reality is that a lengthy pause is likely a prudent path at this point, to more fully assess the impact of the massive tightening of the past year,” Mr. Porter wrote. “After all, every economics student knows that it takes 12 to 18 months for rate hikes to fully affect the economy, and this week marks the one-year anniversary of rate hike number one.″
There have been moments since the January rate decision at which the Bank of Canada’s pledge to pause rate hikes looked premature. Two weeks after the announcement, Statistics Canada published a blockbuster jobs report showing that the labour market added 150,000 positions in January, 10 times Bay Street’s consensus estimate, while the unemployment rate held steady at 5 per cent.
This was followed by several robust data releases, including retail and wholesale numbers, that seemed to defy warnings of an imminent recession. Financial markets quickly shifted from betting on Bank of Canada interest rate cuts later in 2023, to betting on another quarter-point rate hike this summer and no cuts until 2024.
More recent data have painted a weaker picture of the economy, bolstering the central bank’s argument that interest rates have gone up enough. GDP growth stalled in the final three months of 2022, Statscan reported last week, posting zero growth compared with the Bank of Canada’s estimate of 1.3 per cent.
The January inflation numbers were also more mild than expected. The consumer price index rose 5.9 per cent year-over-year, down from 6.3 per cent in December and below the Bay Street estimate of 6.1 per cent. Inflation measures that capture more recent price trends show underlying inflation running at between 3 per cent and 3.5 per cent.
The Bank of Canada remains worried about service-sector inflation, which is closely tied to the tightness of the labour market and the rapid pace of wage growth. Nonetheless, its latest inflation forecast sees annual CPI inflation dropping to around 3 per cent by the middle of the year and back to the 2-per-cent target by the end of 2024.
Should the Bank of Canada hit pause this week while the U.S. Federal Reserve keeps raising rates, that could put downward pressure on the Canadian dollar. That would make imports more expensive while also juicing Canadian exports – dynamics that could add to inflation. This has led some to speculate that the Bank of Canada may be forced to follow the Fed with more rate hikes.
Canadian Imperial Bank of Commerce chief economist Avery Shenfeld played down this risk in a note to clients.
“The market is already pricing-in a roughly 70 basis point differential between U.S. and Canadian peak overnight rates. Even if that stretched out another quarter point, it likely would mean a very modest exchange rate impact,” Mr. Shenfeld wrote. (A basis point is 1/100th of a percentage point).
“Our view is that the Bank has room to stay on hold even if the ceiling on the U.S. fed funds rate gets through 5.5 per cent,” he wrote. The benchmark Federal funds rate is currently in the range of 4.5 per cent to 4.75 per cent.