E-Sight Weekly: E-Sight July 20: Bank of Canada Spikes Rates, Housing Contraction Begins, Watch for Inflation above 8% this Week

As discussed in two E-sights last week, the Bank of Canada delivered a surprise one full percentage point interest rate hike, lifting the overnight rate to 2.50 per cent and signaling more to come. The Bank’s aggressive tightening has inverted the Canadian yield curve, sending a potential recession signal but time will tell if that signal is accurate. The Bank noted that it “decided to front-load the path to higher interest rates”, which is central bank speak for doing more sooner rather than later. So, the next hike on September 7th should be smaller. The question is whether it will be 75 basis points or 50 basis points. After that, the following meeting is on October 26th and it will also have the release of a Monetary Policy Report and a Press Conference. I think this would be an ideal meeting to deliver one more hike, perhaps another 50 basis points, and signal a pause to assess how the rapid tightening is impacting inflation and the economy. This would put the overnight rate at 3.50-to-3.75 per cent, which is a restrictive stance for monetary policy and an appropriate level to take a breather. 

The rapid increase in interest rates will have a dampening impact on domestic demand and, with a lag, will take some steam out of excessively tight labour markets. Even before last week’s supersized hike, the residential real estate market was feeling the bite. The latest Canadian Real Estate Association data showed a 6.2 per cent decline in residential and non-residential unit sales in June and a 20 per cent drop in the second quarter. From their peak in February, residential home prices are down 14 per cent – but this is largely due to fewer large price home selling. Adjusted for the size of dwelling, prices are down 3.3 per cent, however, they have been retreating for three months and price are likely to continue to fall in the months ahead. Indeed, after the recent Bank of Canada rate hike, new home buyers taking a five-year conventional mortgage new to qualify with a mortgage stress test as if they would be taking on a mortgage with an interest rate of between 7 to 8 per cent. This alone will take many buyers out of the market, and interest rates are not done rising. The weakness in real estate will continue as the economy softens and this will weigh on consumer spending both in terms of reduced purchases of housing-related items but also through lower consumer confidence and a negative wealth effect. 

Meanwhile, the pace of home construction will diminish. Today, Statistics Canada reported that housing starts fell to 273k in June from 282k in May. This is still a very strong level, but the trend will continue in the months ahead.

The Bank of Canada has a tough battle to adjust expectations. Prior to their latest hike, businesses and consumers were anticipating that inflation would remain above the 1-to-3 per cent target band over the next two years. If higher inflation expectations get built into contracts and wage settlements, then inflation will be above target. So, the Bank has to alter expectations. But will it be successful?

Workers are going to demand higher wages to reflect the rapid rising cost of living. The Bank wants businesses to say ‘No’ because inflation won’t stay high or there is a risk of a turn in the business cycle. Similarly, the Bank wants the risk of recession and the commitment to do what it takes to fight inflation to convince workers not to demand higher wages because of job insecurity or because inflation won’t stay high. In other words, the Bank of Canada delivered a massive interest hike last week to send a powerful message to businesses and workers and shift their expectations. 

Do you think the message the Bank sent was heard, is credible and will change expectations? If your answer is ‘Yes’, then the Bank will not have to raise interest rates as high to fight inflation and the risk of recession is lower. If your answer is ‘No’, then the risk of a recession is higher because the Bank will have to fight harder to depress inflation expectations and price pressures. 

Last week, US inflation surprised on the upside, reaching 9.1 per cent in June – a new four decade high. A jump in energy prices was anticipated, but broad-based price gains in other components were less so. Given the recent evidence of softer consumer spending and rising inventories, many forecasters had predicted a weaker showing in core CPI. In the wake of the report, financial markets started to price in the possibility of a 100 basis point hike by the Federal Reserve at their July 26-27 FOMC meeting. 

This week’s main Canadian economic release will be the Consumer Price Index (CPI) for June on Wednesday July 20th. Expectations are for the headline inflation rate to jump to 8.4 per cent from 7.7 per cent in May. The increase is expected to be fueled by higher energy prices. Core inflation is expected to come in at 5.9 per cent, down slightly from 6.1 per cent in May. 

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

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