The Bank of Canada is expected to announce its first oversized interest-rate hike in more than two decades this week after hawkish comments from the country’s top central bankers and growing signs that the economy is overheating.
Governor Tiff Macklem and his team have so far taken a gradual approach to tightening monetary policy, keeping borrowing costs near record lows and changing policy levers in a deliberate manner.
But with inflationary pressures broadening, and Russia’s invasion of Ukraine sending energy and food prices soaring, bank officials appear ready to push Canadian interest rates up aggressively.
There is a broad consensus among Bay Street economists that the central bank will raise its policy interest rate by half a percentage point at its Wednesday rate announcement, instead of the usual quarter percentage point. The last time it did this was in May, 2000.
This coincides with a growing sense that central bankers waited too long to start raising rates, and that the world may be entering a period of persistently higher inflation
Deputy governor Sharon Kozicki gave credence to the idea of an oversized rate hike in a speech last month. She said the bank was “prepared to act forcefully” to combat inflation, which hit a three-decade high of 5.7 per cent in February. She added that the governing council would likely discuss both the pace and magnitude of increases ahead of the April 13 rate decision – a strong hint that a half-percentage-point rate hike is on the table.
The Bank of Canada kicked off a rate-hike cycle last month, increasing its policy rate to 0.5 per cent from 0.25 per cent. Borrowing costs are still well below normal levels, and analysts expect the bank to proceed with a quick succession of rate hikes, pushing the policy rate above the prepandemic level of 1.75 per cent by the end of the year.
Recent economic data has bolstered the case for a half-percentage-point move this week.
On Friday, Statistics Canada reported that the country added another 73,000 jobs in March, bringing the unemployment rate down to 5.3 per cent, the lowest in nearly five decades of comparable data. Meanwhile, a Bank of Canada business survey, published last week, showed that companies are struggling with labour shortages and rising input costs, and are planning to pass higher expenses to consumers.
This suggests that the Canadian economy has fully recovered from the pandemic downturn and is now bumping up against capacity limits, Royal Bank of Canada economist Claire Fan said in an interview.
“If you were to wake up today from a coma, you would have thought we’re in a sort of late-stage economic cycle where there’s really no reason for interest rates to stay at historically low supportive levels,” she said.
The Bank of Canada is not alone in signalling a more aggressive path for higher rates. Other central banks, most notably the U.S. Federal Reserve, have pivoted in recent months from defending ultraloose monetary policy to forecasting a rapid rise in borrowing costs.
As recently as December, most Fed officials were expecting no more than three rate hikes in 2022. Now, the majority expect to increase the fed funds rate at least six more times this year, according to projections published mid-March.
The sudden change at the Fed, the Bank of Canada and other major central banks has led to sharp repricing of global bond markets, as investors adjust their portfolios to account for a much faster pace of monetary policy tightening than previously expected. The yields on two-year Government of Canada bonds, for instance, nearly doubled over the past month, hitting 2.45 per cent on Friday, a level not seen since 2008.
With price growth broadening beyond manufactured goods, and starting to show up in services, policy makers are growing concerned that the world is entering an era of stubbornly high inflation, not seen since the 1980s. Agustin Carstens, general manager of the Bank for International Settlements, an umbrella organization for the world’s central banks, focused on this theme in a speech last week.
“New pressures are emerging, not least from labour markets, as workers look to make up for inflation-induced reductions in real income. And the structural factors that have kept inflation low in recent decades may wane as globalization retreats,” he said.
“If my thesis is correct, central banks will need to adjust, as some are already doing. For many years now, having conquered inflation, they have had unprecedented leeway to focus on growth and employment. … But this is now no longer possible, since low and stable inflation must remain the priority,” he said.
The biggest concern for Mr. Macklem and his team is keeping inflation expectations anchored. The longer inflation exceeds the bank’s 2-per-cent target, the more likely it is that people will start to expect prices to keep shooting up. This can be a self-fulfilling prophecy as businesses and workers, respectively, set higher prices and demand higher wages based on where they think inflation is going.
“What we’ve learned from history is that the economy just does not work well when inflation expectations become unmoored,” Mr. Macklem said in early March, noting the economic challenges of the 1970s, when people did not trust the central bank to stabilize the value of money.
“Everybody felt like they were getting ripped off, because they’d get their paycheque, but prices would go up. There were a lot of strikes, there was a lot of labour strife,” he said.
Alongside a rate hike, analysts expect the Bank of Canada to start shrinking its holdings of federal government bonds this week.
This process, known as quantitative tightening (QT), is essentially the reverse of the bank’s quantitative-easing program, which saw it buy more than $300-billion worth of Government of Canada bonds in the first year and a half of the pandemic.
The bank does not plan to sell these bonds, but it will begin letting them mature without replacing them. Around 40 per cent of the bank’s bond holdings mature within the next two years, meaning that its balance sheet could shrink quite rapidly once QT begins.
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