BoC needs to stay the course, though banking stress could impact monetary policy, Macklem says

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Bank of Canada Governor Tiff Macklem said stress in the global banking system could tighten credit conditions in Canada and impact the path of interest rates, but he added that his chief concern is still inflation proving more stubborn than expected.

In a speech to the Toronto Region Board of Trade on Thursday, Mr. Macklem said the central bank needs to “stay the course” on interest rates to ensure that inflation doesn’t get stuck above the bank’s 2-per-cent target. The central bank paused its interest-rate hike campaign in March, and kept its policy rate steady at 4.5 per cent in April.

At the same time, he acknowledged that recent financial system turmoil could be a curveball for monetary policy, potentially forcing the bank to lower interest rates earlier than expected if banking-sector strain gets worse and spills across the border.

So far, Canada has largely been insulated from banking tumult in the United States and Europe, which began in March and continued this week with the failure of First Republic Bank and a sell-off in U.S. regional bank stocks. But Mr. Macklem warned that “financial stability risks remain.”

“If global financial stress were to re-emerge and prove more pervasive, the spillover effects into Canada could be more significant. In addition, global stress could interact with domestic vulnerabilities related to high household indebtedness and the potential for a more pronounced contraction in the housing market,” he said.

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Mr. Macklem emphasized that this is not the scenario the Bank of Canada considers most likely. U.S. and European regulators have acted forcefully over the past two months to prevent contagion from spreading through the financial system. Mr. Macklem said he expects the stress to “remain contained.”

Still, banking-sector problems have changed the inflation-fighting equation for central bankers around the world.

Financial system stress usually leads to a contraction of credit, as commercial banks pull back on lending and regulators introduce stricter capital and liquidity rules to prevent future bank runs.

Some central bankers, notably U.S. Federal Reserve chair Jerome Powell, have suggested that this could act as something of a substitute for monetary policy tightening. The Fed raised its benchmark interest rate by a quarter percentage point on Wednesday, but hinted that its rate-hike campaign may be over.

Mr. Macklem suggested this dynamic could play out in Canada. “If financial stress were to lead to more tightening than expected, and if this were to persist, we would need to take this into consideration as we set the policy rate to achieve our inflation target,” he said.

Over the past two months, several central banks have needed to step into their traditional roles as lenders of last resort. After the failure of Silicon Valley Bank, the Fed began pumping large amounts of liquidity into the U.S regional banking sector to forestall further bank failures. In March, the Swiss National Bank backstopped Credit Suisse to keep it afloat until it could be taken over by rival UBS Group.

While the Bank of Canada hasn’t had to take any such actions, Mr. Macklem said it remains prepared to support financial institutions and intervene in dysfunctional markets if necessary.

Despite the talk of financial-sector strain, much of Mr. Macklem’s speech focused on the challenge of getting inflation back to the bank’s 2-per-cent target. The annual rate of inflation has declined steadily since last summer, falling from 8.1 per cent in June to 4.3 per cent in March. The central bank expects it to reach 3 per cent by the summer, but bank officials remain concerned that getting all the way back to 2 per cent could prove a long and difficult process.

“For services price inflation to slow enough for overall inflation to get back to the 2-per-cent target, several things still need to happen: the labour market needs to rebalance, corporate pricing behaviour needs to normalize, and near-term inflation expectations need to come down further,” Mr. Macklem said.

“There is a risk that these adjustments will take longer or stall, and inflation will get stuck materially above the 2-per-cent target.”

This concern has kept Mr. Macklem and his team on a war footing. Although the bank halted its rate-hike campaign in March, central bank officials have said they could raise interest rates again if needed, and have pushed back on market expectations that the bank will start cutting rates later this year.

The bank’s governing council considered raising the bank’s policy rate at its most recent rate decision on April 12, but decided to stand pat. Interest rate increases work with a considerable lag, and Canada’s central bankers have said they want to wait to see if interest rates are now high enough to bring inflation down over time.