The Bank of Canada laid down its final preparations Wednesday for a sustained campaign against inflation, but stopped just short of launching the first of what it signalled will be a series of interest rate increases.
Policy makers decided to keep the central bank’s key interest rate at a record low 0.25 per cent, where it has been since the early days of the COVID-19 pandemic. At the same time, they indicated that the economy had returned to full capacity and that the bank’s priority now is getting inflation back under control by raising borrowing costs.
The decision marks the end of nearly two years of emergency monetary policy stimulus, setting the stage for rate hikes to begin at the bank’s next policy meeting, on March 2.
“We all agreed it was paramount that we take action to ensure that this rise in near-term inflation expectations doesn’t start to migrate to medium- and long-term inflation expectations,” bank Governor Tiff Macklem said in a media conference after the rate announcement.
“Everybody should expect interest rates to be on a rising path,” he said. “A path is not one move. A path is a number of steps.”
The bank disappointed many financial market participants, who believed the surging rate of inflation, which hit a 30-year high of 4.8 per cent in December, and rising fears about price pressures among consumers and businesses would compel the central bank to begin raising rates immediately.
“Markets had essentially given the bank a green light to start hiking but it opted not to,” wrote Capital Economics senior Canada economist Stephen Brown in a note to clients.
But the bank did drop its forward guidance statement – an explicit pledge included in every rate announcement since mid-2020 that it would not raise rates until the economy had returned to full speed – removing the last policy hurdle to begin gradually increasing the cost of borrowing over the coming months.
The strength and persistence of inflation caught central bankers around the world by surprise in recent months, forcing many of them to change their narrative about inflation and prepare to hike rates. The U.S. Federal Reserve also signalled Wednesday that it will likely begin raising rates in March, putting it in sync with the Bank of Canada as both central banks enter a rate-hike cycle.
Mr. Macklem stressed that despite the lack of a rate hike, the announcement represented “a significant shift in monetary policy.” He defended the bank’s decision to first drop forward guidance before taking the next step to actually raise the key rate.
“By being clear and deliberate, we’re really trying to cut through the noise, so that monetary policy is more of a source of confidence, not another source of uncertainty,” he said.
The governor also cited the rise of the Omicron variant of COVID-19 as a reason for the bank’s decision to wait on raising rates, saying it presents “a new wild card” for the economic outlook, although the bank expects the impact of the Omicron wave to be relatively short-lived.
Dawn Desjardins, deputy chief economist with Royal Bank of Canada, said the central bank was taking a prudent approach, and holding off raising rates until March would not have much of an impact on the path of inflation.
“To my mind, we’re still in a pretty uncertain environment. I think most people believe that Omicron is not going to be doing as much damage to the economy as the other waves did, and that we will start to resume faster economic activity in the months ahead. But there’s still a risk,” she said in an interview.
Derek Holt, head of capital markets economics at Bank of Nova Scotia, took a dimmer view of the bank’s decision to hold its fire.
“The central bank has retained an ongoing run-hot bias toward inflation and house prices as it is far behind the appropriate stance of monetary policy for this point in the cycle,” Mr. Holt wrote in a note to clients.
The Bank of Canada has a long way to go in its fight with inflation. On Wednesday it published a new economic forecast in its quarterly monetary policy report (MPR). This shows consumer price index inflation averaging 4.2 per cent in 2022, a substantial increase from its forecast of 3.4 per cent last October.
The bank expects the rate of inflation to be around 3 per cent by the end of the year, and around 2.25 per cent by the second half of 2023.
The bank continues to place most of the blame for high inflation on rising energy prices and supply chain disruptions, which have pushed up the cost of goods dramatically. The MPR says nearly four percentage points of inflation are tied to energy prices and prices for “components subject to supply constraints.”
Canada’s economic growth was significantly stronger in the second half of 2021 than the central bank had anticipated, bringing employment and output to full capacity sooner than the bank had forecast – a key condition for the Bank of Canada to begin raising rates.
Employment has rebounded from pandemic lows, with Canada adding around 885,000 jobs in 2021 and the unemployment rate falling to 5.9 per cent, just 0.3 percentage points above the rate in February, 2020.
Meanwhile, labour shortages are widespread and businesses are reporting major capacity constraints, with four in 10 saying an inability to find workers is holding back their sales, according to a recent Bank of Canada survey of businesses. That’s feeding into plans to raise wages, with around 80 per cent of survey respondents saying they intend to raise wages at a faster pace over the next year than over the previous year.
Prior to Wednesday’s decision, markets were pricing in six quarter-percentage-point rate hikes in 2022, while most private-sector economists predicted at least three rate hikes. Economists estimate the policy rate needs to get up to around 2 per cent before the bank is in a position where it is neither stimulating nor holding back the economy.
Canadian bond yields dropped after the rate announcement, as investors moved back their expected start date for rate hikes.
“The announcement might be having some market participants rethinking their bets for an aggressive hiking cycle this year,” wrote Royce Mendes, Desjardins’ head of macro strategy, in a note to clients.
The bank ended its government bond buying program, known as quantitative easing, in November. It is now in what it calls the reinvestment phase, in which it only buys bonds to replace ones it already owns as they mature.
On Wednesday, it said that it will keep its holdings of Government of Canada bonds “roughly constant” at least until it begins to raise the policy interest rate.
“At that time, the Governing Council will consider exiting the reinvestment phase and reducing the size of its balance sheet by allowing roll-off of maturing Government of Canada bonds,” the bank said.
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