The Bank of Canada is signalling that it may need to raise its policy interest rate to 3 per cent or more to get a handle on consumer price growth and to prevent Canadians from losing faith in the central bank’s inflation target.
The bank announced its second consecutive half-point interest-rate hike on Wednesday, bringing its benchmark rate up to 1.5 per cent.
Bank officials have previously said they intend to get the policy rate to a “neutral” level of between 2 per cent and 3 per cent relatively quickly. In a speech Thursday, deputy governor Paul Beaudry said there is a growing probability the bank will need to move to the top end of this range or above.
“Price pressures are broadening and inflation is much higher than we expected and likely to go higher still before easing,” Mr. Beaudry said in a speech to the Chambre de commerce de Gatineau.
“This raises the likelihood that we may need to raise the policy rate to the top end or above the neutral range to bring demand and supply into balance and keep inflation expectations well anchored.”
The Bank of Canada is in the middle of an aggressive rate-hike cycle aimed at slowing the pace of inflation, which hit a 31-year-high annual rate of 6.8 per cent in April.
After holding borrowing costs at record lows for the first two years of the COVID-19 pandemic, the bank began raising interest rates in March, and has now moved at three consecutive rate decision meetings. This includes two oversized 50-basis-point increases, in April and again this week. It typically moves in 25-basis-point increments.
On Wednesday, the bank said it is “prepared to act more forcefully if needed.” Analysts took this to mean that the bank is open to a possible 75-basis-point rate hike – which would be the biggest rate increase since the 1990s. The bank has four more rate announcements this year, with the next on July 13.
Mr. Beaudry seemed to confirm this idea in a news conference after the speech. He said moving “more forcefully” could involve “doing more moves in a row, or it could involve bigger moves. All this will depend exactly on the data that comes in. We’re not doing anything on automatic pilot.”
Higher interest rates can’t do much to deal with international sources of inflation, which include persistent supply chain bottlenecks, COVID-19 lockdowns in China and surging commodity prices following Russia’s invasion of Ukraine.
But raising borrowing costs will dampen demand in the Canadian economy. This is important because consumer prices are increasingly being pushed up by domestic factors, as demand outstrips supply in Canada’s overheating economy.
The key concern for the central bank is making sure inflation expectations don’t become unanchored from the bank’s 2-per-cent inflation target. Where people think consumer prices are headed has a significant impact on where prices end up. Businesses set prices and employees negotiate wages based on their beliefs about inflation, which can create a kind of self-reinforcing cycle.
“The longer inflation remains well above our target, the more likely it is to feed into inflation expectations, and the greater the risk that inflation becomes self-fulfilling,” Mr. Beaudry said.
“History shows that once high inflation is entrenched, bringing it back down without severely hampering the economy is hard. Preventing high inflation from becoming entrenched is much more desirable than trying to quash it once it has,” he said.
Royce Mendes, head of macro strategy at Desjardins Capital Markets, said in a note to clients it could be difficult for the Bank of Canada to get its policy rate close to 3 per cent or above. The Canadian economy is highly interest-rate sensitive, given the overheated housing market and highly indebted households, Mr. Mendes noted.
“In the last cycle the central bank told a similar story about getting rates up towards the 3 per cent range, but was only able to push the policy rate up to 1.75 per cent. At that point, the housing market and consumer spending began to weaken so dramatically that rate cuts were on the table even before the pandemic,” Mr. Mendes wrote. He expects the bank to stop moving once it gets the policy rate to 2.25 per cent.
There are already signs the housing market is cooling in response to higher interest rates. The number of home sales across the country fell 12.6 per cent from March to April on a seasonally adjusted basis, while the home price index slid 0.6 per cent, according to the Canadian Real Estate Association.
Mr. Beaudry acknowledged the Bank of Canada is walking a fine line as it tries to slow the economy without triggering a recession.
“We’re aiming for this soft landing, but it is a difficult compromise. You do a little bit too little and you kind of allow inflation to keep going and that becomes entrenched. … And if you do too much you kind of might bring the economy into a recession. So we’re trying to aim at that in-between,” he said.
Asked whether the bank would be willing to engineer a recession to get inflation under control, Mr. Beaudry was blunt: “We’ll try to do it in a way that’s the best for Canadians. But bottom line is we’ll get inflation back to 2 per cent, and we’ll do what’s necessary to get it there.”
While much of the speech was forward-looking, Mr. Beaudry also offered the clearest explanation to date about why the Bank of Canada’s governing council waited until the spring of 2022 to start raising interest rates. That decision has been criticized by private-sector economists, who say the bank was slow to begin tightening monetary policy, particularly once it became apparent last fall that high inflation would not be transitory.
Mr. Beaudry said the bank was weighing risks and making decisions based on how inflationary shocks played out in the past. He said that much of the inflationary pressure last year came from international forces, such as higher oil prices, which tend to be temporary. Moreover, the Canadian economy was operating below its potential for much of the year, a situation that typically implies low domestic inflation.
“Finally, amid successive waves of the pandemic, we knew that premature tightening could impede the ability of people who lost jobs during the pandemic to find work again,” he said.
There was always a risk that inflation would prove more persistent than the bank anticipated, and that it would become entrenched, Mr. Beaudry said. But he said that “this risk seemed appropriate to take at the time, given the slack in the economy and the view that the supply-driven sources of elevated inflation would likely prove temporary.”
“The situation today is notably different,” he said.
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Mark Rendell