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Bank of Canada Governor Tiff Macklem speaks during a news conference in Ottawa on Dec. 15, 2021. Mr. Macklem has suggested that the bank could move in stages, conducting a few rate hikes then pausing to assess the economic impact of the changes.BLAIR GABLE/Reuters

After months of blistering inflation, economists and investors are betting the Bank of Canada will start raising interest rates on March 2, kicking off a brisk rate hike cycle that could see borrowing costs return to pre-COVID-19 levels or surpass them some time next year.

Central bank officials have said they may need to move forcefully to tamp down inflation expectations, which are at risk of becoming unmoored the longer consumer price growth remains high. That doesn’t mean Governor Tiff Macklem and his team are preparing to push interest rates up into double digits, as central bankers did in the early 1980s to bring spiralling inflation back under control.

“We’re not talking about 18 per cent interest rates to cool the economy,” said Royce Mendes, head of macro strategy at Desjardins.

“We can look back at the last cycle [in 2017 and 2018], and realize that when rates got to 1.75 per cent, we could see clear signs in the housing market and in the durable goods market that higher interest rates were taking a toll. So that provides a rough guide,” he said.

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To put that in terms of how most Canadians experience interest rates, when the bank’s policy rate was last at 1.75 per cent, the prime rate – which commercial banks use to determine variable-rate mortgages and home equity lines of credit – was at 3.95 per cent. Currently the prime rate is 2.45 per cent.

Financial instruments that track market expectations for interest rates are pricing in seven quarter-point rate hikes this year, which would bring the policy rate from 0.25 per cent, where it’s been since March, 2020, up to 2 per cent. That would be higher than rates have been since the Great Recession of 2008-09, but still low by historical standards. Market pricing also implies a “terminal rate” of around 2.25 per cent for the rate hike cycle.

How fast rates rise and how high they go, ultimately depends on a range of factors: housing market strength, rate hikes by the U.S. Federal Reserve and the pace at which Canadians spend extra money saved during the pandemic, among other variables.

The Bank of Canada expects inflation to remain close to 5 per cent until the middle of the year, then start declining rapidly in the second half of the year, as supply chain problems related to the pandemic diminish. But if that doesn’t happen, the bank’s governing council may have to speed up its pace of rate increases.

Mr. Macklem has suggested that the bank could move in stages, conducting a few rate hikes then pausing to assess the economic impact of the changes.

“The bank will probably tighten by at least by 100 basis points [or one percentage point], and we won’t really see much of an impact in the economic data,” said Stephen Brown, senior Canada economist with Capital Economics.

“It’s when we start approaching that 1.5 per cent level, where we need to start paying closer attention to the housing market and the components of retail sales, like the building material, garden equipment, which are related to renovations,” he said.

Mr. Brown said the Canadian economy is particularly sensitive to rising borrowing costs because of how much of the country’s GDP is tied to the housing sector. This dynamic has increased over the past two years, as home prices have exploded and new buyers have taken on larger mortgages – factors that could limit how high rates can go before becoming too much of a drag on the economy.

“Can the housing market withstand a return to prepandemic mortgage rates even though house prices have risen by 40 per cent in the interim? I just don’t think it can,” Mr. Brown said, adding that he expects the bank’s policy rate to peak at around 1.5 per cent about a year from now.

One guidepost for how high rates may go is the so-called neutral rate: the interest rate at which the economy is neither being stimulated nor held back. This is a theoretical rate that cannot be observed directly. The Bank of Canada estimates it lies somewhere between 1.75 per cent and 2.75 per cent.

At a recent news conference, Mr. Macklem said the central bank may need to lift its policy rate above the neutral rate if inflation remains stubbornly high. Although he added that the bank could also stop short of the neutral rate if “new headwinds emerge” that dampen economic growth.

“The principal factors that would cause the BoC to speed up their tightening would be a de-anchoring higher of medium-term inflation expectations and/or stronger wage cost pressures,” Simon Deeley, director of Canada rates strategy at the Royal Bank of Canada, said in an e-mail.

RBC is forecasting four rate hikes this year, followed by two next year, which would bring the central bank’s overnight rate back up to 1.75 per cent, where it was before the pandemic.

There has been some speculation that the Bank of Canada could start with a 0.5-per-cent rate increase at the March 2 meeting, instead of the usual 0.25-per-cent increase. Mr. Deeley thinks this is unlikely. “They have emphasized being deliberate in their approach, and if they were feeling behind the curve, then they likely would have lifted off at the January meeting instead,” he said.

Alongside rate increases, the Bank of Canada will also be tightening monetary policy by shrinking the size of its balance sheet. Over the first year and a half of the pandemic, the bank bought hundreds of billions worth of federal government bonds as part of its quantitative easing (QE) program, aimed at holding down long-term interest rates.

The bank ended QE in October and stopped expanding its balance sheet, but it has not yet begun to shrink its holdings. That process, known as quantitative tightening, will theoretically push up long-term interest rates and tighten monetary policy.

Deputy Governor Tim Lane said in a speech last week that the bank would decide whether to start letting bonds mature and its balance sheet shrink after the first rate hike. He strongly hinted that this process will begin shortly.

Mr. Mendes of Desjardins said shrinking the balance sheet will likely only have a modest impact on interest rates, although it could help improve functioning of the bond market.

“What will be more interesting is the path of the Federal Reserve’s balance sheet, because that affects global interest rates,” Mr. Mendes said.

Fed officials plan to end the U.S. quantitative easing program in March, and are widely expected to begin raising rates that month.

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