OTTAWA—The Bank of Canada is trying to remove excess demand from the economy, and contrary to what some economists believe, it says it can achieve the “soft landing” of getting inflation back to its 2 percent target while avoiding an economic recession.
Canada’s central bank upped its trendsetting interest rate by 100 basis points—a full percentage point—to 2.5 percent on July 13 in a move that surprised the markets, as it was the largest one-time rate increase since 1998. A move of three-quarters of a percentage point had been widely expected after the U.S. Federal Reserve raised its federal funds target range by 75 basis points on June 15.
“The Governing Council decided to front-load the path to higher interest rates,” according to the BoC’s press release.
A key message from the central bank is that by front-loading interest rate increases now, greater pain from having to raise rates even higher down the road can be avoided.
“Front-loaded tightening cycles tend to be followed by softer landings,” Bank of Canada governor Tiff Macklem said in his opening remarks at the bank’s press conference.
Macklem explained that by targeting excess demand, which he said has really only built up “in the last number of months,” the BoC aims to give the supply side time to catch up.
“Today was more forceful,” Macklem added, saying that the “very unusual” move of 100 basis points at one time reflects the exceptional circumstances in the Canadian economy.
Inflation is nearly at a 40-year high, at almost 8 percent, and the BoC said it will remain around that level for the next few months.
The BoC also signalled that rates will need to rise further. It had already raised the overnight rate by 125 basis points this year prior to the July 13 rate hike.
Evidence of Skepticism
The Bank of Canada is expecting inflation to ease to about 3 percent by the end of 2023 before returning to the 2 percent target by the end of 2024.
Macklem said he recognized that the BoC’s credibility is being tested on its ability to achieve its 2 percent inflation target.
Carleton University economics and philosophy professor Vivek Dehejia had earlier told The Epoch Times that “for the [2 percent inflation] target to have any credibility at all, the bank has to be seen to be taking aggressive action.”
However, he said hiking rates by more than 75 basis points would not be a good idea, although 50 basis points would be too “timid.”
Oxford Economics director of Canada economics Tony Stillo said in a July 13 note to clients that the 100 basis points hike is “overly aggressive” and another such rate hike “risks aggravating Canada’s household debt and housing imbalances, potentially plunging the economy into recession.”
TD Securities said the front-loading comment implies the scope for rate hikes going forward will be slower and it expects a rate increase of at least 50 basis points in September.
“We expect a rapid change in tone in Q4 however, as at that point we expect that growth will be slowing under strain of significantly tighter financial conditions. Consequently, we continue to look for a terminal rate of 3.25 percent in October, with rate cuts following in late 2023,” TD Securities said in a note.
The Bank of Canada projects the Canadian economy will grow 3.5 percent in 2022 before slowing to 1.75 percent in 2023. This is a downgrade from April’s projections, where 2022 growth was projected to be 4.25 percent and 2023 growth 3.25 percent.
The growth projection for 2024 picks up to 2.5 percent when housing stabilizes and is no longer a drag on economic growth.
RBC has its doubts about the Bank of Canada’s growth forecasts.
“We think the BoC’s forecasts are optimistic, with growth likely needing to slow more materially next year if domestic inflationary pressure is to be brought under control in any reasonable timeframe. In our view, a soft landing will be difficult to achieve and our forecast now assumes a mild recession next year,” said RBC senior economist Josh Nye in a note.
RBC also expects the BoC’s policy rate to be 3.25 percent in October. The Bay Street bank said the 100 basis points move wasn’t out of the question, however.
Macklem supported his call for avoiding a recession by noting that given the over 1 million job vacancies, there is room to reduce those vacancies without significantly increasing the unemployment rate, as would happen during a recession. He also pointed out that high commodity prices bring more income into Canada, unlike many of its trading partners.
Stillo said in a July 6 note that, although a soft landing is still the most likely outcome, soft landings are more the exception than the rule in cases where the central bank aggressively raises rates. He pointed to seven recessions in the last 50 years—excluding the 2020 lockdown recession—where gross domestic product (GDP) has fallen on average 2.5 percent over three quarters.
Rising Inflation Expectations
Notably, the central bank is showing greater concern about rising inflation expectations based on its surveys of businesses and consumers, which indicated that those groups are expecting inflation to remain higher for longer.
In its monetary policy report (MPR), the central bank said that those survey results suggest greater uncertainty over the future path of inflation, which raises the risk of inflation expectations becoming de-anchored and moving further away from the 2 percent inflation target. The MPR illustrated how the distribution of inflation expectations has widened and shifted higher as compared with the situation in April.
“People are seeing what’s going on and obviously that affects the way the public views future inflation. So expectations are coming unanchored. And that is a really, really big, big problem,” Dehejia said.
Canada, as a medium-sized and open economy, imports inflation from external sources through channels like energy and food prices, and the BoC has emphasized how devastating the conflict in Ukraine has been to supply chains and costs.
“Higher interest rates will do little to address these factors and may even exacerbate them,” Stillo said.
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