Commentary
The Bank of Canada (BoC) has raised the key overnight rate to 5 percent and the Bank Rate to 5.25 percent. The increases of one-quarter of a percent were widely anticipated by market observers. Coincidentally, the U.S. Consumer Price Index (CPI) for June was released and the core rate, at 3 percent, was lower than expected. Bond and stock markets rallied during the morning.
The BoC continues to demonstrate its concern about inflationary pressures in the economy. Core measures of inflation remain above the stated target of 2 percent despite Canadian inflation dropping from a high of 8.1 percent last summer to 3.4 percent in May. If we can generalize the previous consensus of market players and analysts, inflation has remained higher for longer than most expected and the economy has remained resilient, as many expected a recession by now.The BoC stated that they expect inflation to be about 3 percent next year. This is above the Bank’s 2 percent target. In effect, the Bank has reiterated its previous comments that Canadians can expect higher rates for the next year or two and not to expect any rate relief as they renegotiate their mortgages. An already stretched Canadian consumer will have to belt-tighten and plan their financial lives in a relatively high-rate environment, at least compared to the post-Great Financial Crisis era. We do not appear to be returning to extraordinarily low interest rates any time soon.
Consumer spending was significantly more than expected in the fourth quarter of 2022. Perhaps this was more a result of consumers relying on credit cards and other forms of debt. Many Canadians facing higher mortgage rates are being allowed by their lenders to lengthen their amortization periods to keep up their spending levels. In effect, some borrowers are de facto taking out reverse mortgages to buy groceries. The effect will be to curtail future spending as homeowners will be paying their mortgages off over a longer period than otherwise and will build less home equity, thereby sacrificing their net worth.
The Bank of Canada expects GDP growth to be a lethargic 1.8 percent in 2023 and an almost recessionary level of 1.2 percent for the full 2024 year. The first half of 2024 may be especially weak. Growth for 2025 is expected to be between 2 percent and 3 percent. This weak growth is likely why the Bank has not raised rates by even more.
Labour markets are expected to be tight both in Canada and in most high-income nations. This is being offset by the large increase in Canada’s already high immigration rate. The official view is that new immigrants will ease labour shortages. We would be cautious on this view. New immigrants may not immediately be able to fill positions with the exception of low-paying and low-skilled jobs.
Furthermore, we should remember that central bankers and senior officials almost never forecast recessions, probably for what they think are good reasons. The probability of recession remains high if we look at the U.S. Composite Index of Leading Indicators and the yield curve. In the past, these metrics have been far more accurate in predicting economic downturns than central bankers and economists on the payrolls of financial institutions.
A retired and prominent Canadian chartered bank economist confessed to me that if he predicted no recession and was wrong, he would keep his job because almost every high-profile player would also be wrong. However, if he predicted a recession and one did not occur, he would be fired and blackballed from working at most prominent institutions.
The BoC remains in a somewhat difficult position. Inflation remains higher than it should and the economic numbers appear mixed. However, metrics like unemployment and spending always lag behind the downturn and politicians in power always generate an optimistic narrative. The Bank is attempting to bring down inflation without torpedoing the economy. Given what we observe worldwide from China to the United Kingdom and other nations, the risks are probably on the slowdown side.
