The Bank of
Canada increased its benchmark interest rate by one percentage point on
Wednesday, the most aggressive rate hike since 1998 and a larger move than
investors and private-sector economists were expecting.
The central
bank’s governing council voted to raise its policy rate to 2.5 per cent from
1.5 per cent. This is the fourth consecutive interest rate increase since
March, and puts the Bank of Canada ahead of its peers when it comes to
tightening monetary policy in the face of the most significant inflation shock
in a generation.
“With the
economy clearly in excess demand, inflation high and broadening, and more
businesses and consumers expecting high inflation to persist for longer, the
governing council decided to front-load the path to higher interest rates,” the
bank said in its rate decision statement.
The bank
signaled that interest rates will need to keep rising to cool down Canada’s
overheated economy and slow the pace of consumer price growth.
Ahead of
Wednesday’s announcement, investors and private-sector economists were widely
expecting a 0.75 percentage point increase. The Bank of Canada’s governing
council, however, opted for a super-sized move in response to broadening
inflation pressures and worrying signs that inflation expectations are becoming
unanchored.
The bank now
expects the rate of inflation to average 7.2 per cent in 2022 and 4.6 per cent
in 2023 – considerably higher than it forecast in April. It does not expect
inflation to return to its 2 per cent target until the end of 2024.
Economic growth, meanwhile, is expected to slow sharply in the second half of the year and into next year, as a combination of high inflation and tighter financial conditions erodes household spending and business investment.
The bank is
not forecasting a recession in Canada in the next two years as its base case.
But its quarterly Monetary Policy Report, published Wednesday, does warn that
the risk of a recession would rise if high inflation becomes baked into
consumer and business psychology, triggering a wage-price spiral.
Wednesday’s
supersized rate hike cements a remarkable pivot that has taken place in recent
months at the Bank of Canada and other central banks around the world.
Governor
Tiff Macklem and his team held interest rates near zero for the first two years
of the COVID-19 pandemic, and were slow to start tightening monetary policy
even as inflation began to pick up last year. This changed in March. Since
then, the bank has been pushing interest rates higher at the fastest pace in
decades.
The annual
rate of inflation hit 7.7 per cent in May, the highest since 1983. Inflation is
becoming impossible to avoid, with more than half of the components of the
consumer price index rising at an annual rate of more than 5 per cent in May.
That’s aggravating cost-of-living concerns for many Canadians.
Higher rates
make it more expensive for businesses and households to borrow money. This
won’t do much to tamp down global inflationary pressures, such as supply chain
bottlenecks and higher commodity prices, which have surged in the wake of
Russia’s invasion of Ukraine. But it could help cool demand in the Canadian
economy.
“While global
factors such as the war in Ukraine and ongoing supply disruptions have been the
biggest drivers, domestic price pressures from excess demand are becoming more
prominent,” the bank noted in its rate decision.
The rapid
rise in interest rates is also aimed at keeping inflation expectations
anchored. One of the biggest concerns for central bankers is preventing people
from losing faith in its inflation target.
The longer consumer prices keep surging, the more inflation will become entrenched in people’s psychology as happened in the 1970s. The fear is that a wage-price spiral could develop, where business and consumers expect higher prices, and so set higher prices and demand higher wages in a self-reinforcing cycle.
“Surveys
indicated more consumers and businesses are expecting inflation to be higher
for longer, raising the risk that elevated inflation becomes entrenched in
price- and wage-setting. If that occurs, the economic cost of restoring price
stability will be higher,” the bank said in its rate decision statement.
Higher
interest rates are already impacting key segments of the economy, notably in
the housing market. In the Toronto region, the largest real estate market in
the country, the number of home resales dropped 41 per cent in June compared to
last year. The typical Toronto home price is down nearly 10 per cent from the
March peak to June.
Mr. Macklem
and senior deputy governor Carolyn Rogers will hold a press conference at 11 am
to explain the bank’s decision.
Written
By: Mark Rendell
Source: The Globe And Mail