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The Bank of Canada has raised its key interest rate by 100 basis points to 2.5 per cent in a bid to curb inflation that policymakers say is at risk of becoming entrenched.
The rise on Wednesday was the biggest in Canada in more than two decades and caught off guard markets that had been expecting a 75bp rise. It puts the benchmark overnight rate at its highest level since 2008. Inflation, at 7.7 per cent in the year to May, is now almost four times the central bank’s 2 per cent target and at its highest level since 1983.
The move followed news that US inflation hit 9.1 per cent in the year to June, raising the prospect of a rate increase of at least 75bp by the US Federal Reserve later this month.
Canada’s central bank said it wanted to “front load” rate rises as inflation had proven “higher and more persistent” than it had flagged in its April monetary policy report and “will probably remain” at about 8 per cent in the next few months.
“Front-loaded tightening cycles tend to be followed by softer landings,” Bank of Canada governor Tiff Macklem said at a press conference on Wednesday.
“We are acutely aware that higher interest rates will affect Canadians who are already feeling the pain of high inflation . . . but by increasing the cost of borrowing, we will moderate spending and return inflation to its target.”
Macklem said the central bank is aiming for a so-called soft landing where it stamps out scorching inflation without causing a recession. But he noted the path was narrowing because price growth has proved more persistent than hoped.
“Consumers and businesses are expecting inflation to be higher for longer, raising the risk that elevated inflation becomes entrenched in price and wage-setting,” the bank said. “If that occurs, the economic cost of restoring price stability will be higher.”
The move comes amid mounting concerns of a recession in Europe and North America, with central bank rate rises and higher energy costs expected to dent growth.
Last week, RBC was the first Canadian bank to predict a recession in the country in 2023. The central bank has not forecast one in its base case, but expects gross domestic product growth to slow to 1.8 per cent next year.
Inflation could spark a recession if a wage-price spiral occurred, with high prices pushing up pay, the Bank of Canada said in its monetary policy report published on Wednesday.
“To break the vicious circle, monetary policy works to re-anchor long-term inflation expectations to the 2 per cent target,” it said. The bank forecast that it would reach the inflation target by the end of 2024.
Macklem also expressed optimism that Canada’s resource-heavy economy would serve as a buffer to a global slowdown in growth because many of the commodities it exports remain at elevated price levels.
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Responding to questions about the bank’s miscalculation in autumn that inflation was “transitory”, he pointed to global factors outside of its control, including “substantially higher oil prices” and snarled global supply chains.
A rapid domestic recovery from the coronavirus pandemic was another reason for the error, Macklem added. As Canada kept rates near zero, people saw their savings balloon, wages rise and housing prices continued to surge, reaching a peak in February.
Wednesday’s rate rise follows 50bp increases in April and June, and a 25bp increase in March. Those have cooled Canada’s hot housing market by pushing up mortgage rates, but the labour market remains tight. The unemployment rate fell to a record low of 4.9 per cent in June. Employers have reported a challenging hiring environment, where workers are demanding higher wages.
More action is expected in the months ahead.
“We are currently forecasting 50bp hikes in September and October with a 25bp move in December,” said James Knightley, economist at ING Bank. “But the odds are certainly moving towards a more aggressive move in September at the very least, especially if inflation shows little sign of abating.”
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