E-Sight July 13: The Bank of Canada Hikes a Full Percentage Point in July to Battle Inflation and Re-Anchor Inflation Expectations

This is a quick commentary after the press release of the Bank of Canada’s rate decision came across the news wires. Further analysis will come after the press conference if warranted, but here is a quick take, because I am getting a lot of immediate questions.

If anyone wondered whether the Bank of Canada took its inflation fighting mandate seriously, those doubts should be put to rest after the Bank choose to hike the overnight rate by a full percentage point in one move today. Canada might have over indebted households. It may have over valued real estate markets. A lot of recent inflation may be coming from supply-side factors. A rapid rise in interest rates could run the risk of triggering a recession. None of that will deter the Bank from doing what is necessary to bring inflation back to within the 1-to-3 per cent target band. 

The Bank’s decision is also supported by the fact that demand factors have become more prominent in contributing to inflation and prices pressures have been broadening out. As we outlined in this week’s E-sight weekly on Monday, the Bank is also concerned that consumer and business inflation expectations are rising and run the risk of becoming entrenched at higher levels. A wage-inflation spiral is also a risk. All of this supported financial market expectations for a 75 basis point hike at today’s announcement, but the Bank decided to be even bolder – or, in central bank speak, “to front-load the path to higher interest rates.” But, even with the greater-than-expected hike, the Bank notes that further increases will be needed to achieve the 2 per cent inflation target. 

The Bank also released updated economic forecasts. It is projecting economic growth of 3.5 per cent growth in 2022, 1.75 per cent growth in 2023 and 2.50 per cent in 2024. The forecasts for this year and next are in line with the latest Deloitte forecasts, but we assumed that the overnight rate would peak at around 3 per cent and it now looks likely that the Bank could take it higher than that. Moreover, Deloitte expects much weaker growth in 2024. In my mind, the Bank of Canada’s outlook looks optimistic given the interest rate shock being delivered by the Bank of Canada and the Federal Reserve to combat inflation. I think we are going to see a much sharper deceleration in growth, particularly in interest rate sensitive sectors of the economy. For example, residential real estate markets are likely to have a correction, and this would have a significant impact on real estate related consumer spending. Recession risks look elevated, and I would still put the odds at around 40 per cent. 

Recession or no, the one thing I can guarantee you is that the Bank of Canada will get inflation back to within its target band by hook or by crook. 

Categories: Bank of Canada, Canadian Economic Outlook, Canadian Inflation, E-Sight, Economics

Tags: , , , , , , , ,

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