As promised from my last note, this is commentary is add-on from my initial take. No real changes, just interesting observations from MPR.
The Bank of Canada surprised markets by delivering a one percentage point increase in the overnight rate and signaled that the tightening cycle is not yet over. The strong decision was accompanied by the release of the Monetary Policy Report (MPR) and press conference that provided an opportunity to fully articulate the central banks thinking about inflation, the risks and the outlook. Here are the salient points.
The Bank expects inflation to average close to 8 per cent this summer – roughly four times the 2 per cent target. This is happening when the economy is at full employment, as evidenced by a record low unemployment rate and high levels of job vacancies. Some of the price pressures have come from supply problems (supply chain disruptions and commodity shocks – in the case of the latter including high energy and agriculture prices caused by the war in Ukraine), but strong domestic demand and domestic firms increasing margins has also played a part. Rising wage pressures and rising inflation expectations threaten to make the inflation environment more persistent and entrenched.
Accordingly, the Bank felt that monetary policy needed to be tightened and that it was prudent to do more of the interest rate increase sooner than later. The monetary authority has been clear that a neutral stance of policy is an overnight rate in a range of 2.00-to-3.00 per cent. Accordingly, today’s increase in the overnight rate to 2.50 per cent moves monetary policy firmly into a neutral position. Given the lack of slack in the economy and the high rate of inflation, I don’t think anyone can argue that this is inappropriate.
The question is how high will interest rates go from here? And, to no one’s surprise, the Bank doesn’t tell us. The Governing Council, who makes the decision on rates, feels that interest rates likely need to rise further, but “the pace of increases will be guided by the Bank’s ongoing assessment of the economy and inflation.” So, the answer is whatever it takes to bring inflation back to target, and the central bank likely isn’t sure of the exact number. Personally, I think we can safely pencil in at least a 50 basis point hike at the next meeting on September 7 and maybe 50 basis points on October 26.
On the inflation front, the Bank of Canada is projecting that headline inflation will average around 8 per cent in the summer and then gradually decline toward 3 per cent by the end of next year. That means we don’t get to the 2 per cent target until 2024. It is expecting the supply side price distortions to gradually fade, while the tightening of monetary policy dampens domestic demand and domestic price pressures. This is reflected in the Canadian economic outlook.
The Canadian economy is expected to slow, with growth of 3.5 per cent this year, 1.8 per cent next year and then pick back up to 2.4 per cent in 2024. The details show the impact of higher interest rates. The Bank has cut is projection for consumer spending growth significantly and is forecasting a contraction in housing investment. One interesting assumption in its forecasts is the outlook for the global economy, particularly the US economy. The Bank is assuming that the US economy grows 1.9 per cent this year (down from a prior forecast of 2.8 per cent) and only 1.1 per cent in 2023 and 2024. This likely reflects the expected impact of the Federal Reserve raising interest rates to fight inflation south of the border. The implication is that the Bank of Canada is expecting the Canadian economy to outperform the US economy by a sizeable margin, which I can see in the near term due to high commodity prices but I am less convinced in 2024.
Overall, the MPR makes it clear how the Bank has modelled the impact of higher interest rates and its forecasts are not very different than the Deloitte forecasts in 2022 and 2023. However, the Bank of Canada and the Federal Reserve are being more aggressive in tightening monetary policy than we had anticipated, and I think there are downside risks to the central bank projections. Consumer spending and real estate investment has been reduced, but I think the combination of the inflation shock and interest rate shock as well as the psychological impact and negative wealth effects could have more adverse effects than modeled. I am also very confused by the Bank of Canada’s profile for growth. It doesn’t appear that any material slack accumulates in the economy in the forecast and the economy is growing at above what I think is a sustainable pace in 2024. It is just my opinion, but I think the Bank’s outlook is a tad optimistic.
The Monetary Policy Report also included an interesting special section outlining a wage spiral scenario. This was a useful illustration that explained how higher wages could push inflation higher, leading to tighter monetary policy and an economic contraction. The Bank notes that it is committed to ensuring that this dynamic does not set in, but the accompanying charts and data are useful scenario inputs.
Lastly, the Bank of Canada included an appendix on the main factors behind their inflation forecast errors. This is good transparency. Not to get too economic nerdy, but the simple answer is that roughly 2/3 of the Bank’s inflation forecast error has been on unexpected price increases from external supply factors. They were generally right about domestic prices – except domestic shelter costs that contributed about 1 percentage point to the inflation error. This assessment is important in addressing some of the criticism that has been leveled at the central bank. The Bank’s inflation forecast error was primarily about not anticipating the price pressures from the breakdown of global supply chains and the loss of the disinflationary influence of globalization rather than the price pressures from the increase in domestic money supply.
Categories: Bank of Canada, Canadian Economic Outlook, Canadian Inflation, E-Sight, Economics
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