In a bold move following the surprising resumption of interest rate hikes, the Bank of Canada is poised to further increase borrowing costs this week, defying the persisting decline in inflation and conflicting indications of the economy’s strength.
Having concluded a five-month pause on tightening monetary policy in June, the central bank raised its benchmark interest rate to 4.75 per cent, reaching its highest level since 2001. While most financial forecasters on Bay Street expect another quarter-point hike on Wednesday, the Bank of Canada is likely to adopt a more cautious approach afterward.
Until recently, few economists anticipated the possibility of rate hikes during the summer, as they believed the Canadian economy would be either in or on the verge of a recession, owing to an aggressive interest rate-hike cycle unmatched in decades.
However, consumer spending and labor markets have exhibited remarkable resilience in the face of heightened borrowing costs, creating complications for Governor Tiff Macklem and his team as they strive to curb inflation. The central bank aims to achieve a standstill in economic growth to alleviate the upward pressure on consumer prices.
Although inflation has experienced a considerable decline, reaching an annual rate of 3.4 percent in May, the bank’s governing council, in June, concluded that the economy was still grappling with “excess demand” and that rates needed to be increased further to prevent inflation from surpassing the bank’s 2 percent target significantly. This week, policymakers face the crucial question of whether an additional rate hike is necessary to accomplish this objective.
Taylor Schleich, the Director of Economics and Strategy at the National Bank of Canada, expressed skepticism about the necessity of further tightening, stating, “We’re not convinced that the economy needs further tightening. But what it comes down to is that five weeks ago the bank told us that policy at 4.5 percent wasn’t restrictive enough. Holistically, if the bank thinks that things weren’t restrictive at 4.5 percent, 4.75 probably isn’t the number either.”
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Financial markets have aligned themselves with this possibility. According to Refinitiv data, interest rate swaps, which reflect expectations regarding future rate decisions, currently indicate a roughly 70 percent likelihood of the central bank implementing a quarter-point hike on Wednesday. Market pricing further suggests that the bank will maintain the status quo throughout the autumn season.
Should another rate hike come to pass, mortgage holders, particularly those with variable-rate or soon-to-be-renewed fixed-rate mortgages, would bear additional burdens. Moreover, it may cast a shadow over the summer housing market. Notably, real estate activity in major markets such as Toronto and Vancouver experienced a noticeable slowdown in June, which some economists attribute to the rate hike at the beginning of that month.
Central banks across the globe are grappling with a similar mix of economic resilience and persistent inflation. The Bank of England and Norway’s central bank surprised observers by implementing larger-than-expected half-point rate increases last month, while other central banks, including the European Central Bank, continue to tighten policy and warn of future rate hikes.
In contrast, the U.S. Federal Reserve held its policy rate steady last month, although committee members have signaled their expectation of two additional rate hikes before the year concludes.
However, despite widespread analyst and market support for a rate increase by the Bank of Canada this week, the case for further tightening has somewhat weakened over the past five weeks. Economic data that was uniformly robust before the June decision has now become more mixed.
The most compelling argument for another hike can be found in the June jobs report. Statistics Canada revealed on Friday that Canadian employers added 60,000 positions last month, three times the market’s expectations. This positive development reversed a slight decline in May and extended Canada’s impressive streak of job creation, which has seen nearly 300,000 jobs added during the first half of the year.
Concurrently, signs of cooling have emerged in the labor market. The unemployment rate rose to 5.4 percent from 5.2 percent, as job creation failed to keep pace with the rapid population growth driven by immigration. Furthermore, the pace of hourly wage growth, a crucial factor in inflation dynamics, particularly within the service sector, decelerated from 5.1 percent in May to 4.2 percent.
Other indicators suggest that the previous rate hikes are beginning to have an impact. Consumer delinquencies have risen, job vacancies are diminishing, and the central bank’s latest business survey found that many companies anticipate a slowdown in sales and a reduction in cost pressures.
The consumer price index inflation continues its downward trajectory, falling from 4.4 percent in April to 3.4 percent in May. Although this marks a significant retreat from last summer’s four-decade high of 8.1 percent, it still hovers just above the upper threshold of the central bank’s inflation-control band. Additionally, measures of “core” inflation, which exclude volatile components such as energy and food, remain persistent.
Leslie Preston, a senior economist at Toronto-Dominion Bank, explained, “The slowing in inflation that we’ve seen recently, it’s largely coming from energy – you’re not seeing the same big increases at the pump that we had last year. So headline inflation is coming down. But the less volatile inflation that the Bank of Canada targets is still well above three percent and it’s not coming down as quickly.”
It is crucial to note that interest rate adjustments typically have a delayed impact. This introduces the risk that the Bank of Canada may inadvertently apply excessive monetary policy pressure just as the economy begins to weaken.
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Andrew Grantham, a senior economist at Canadian Imperial Bank of Commerce, expressed his belief that another rate hike is unnecessary to guide inflation back down to two percent. Nonetheless, he expects the central bank to raise rates again this week based on the bank’s hawkish communication during the June meeting and the strength of the most recent jobs data.
“We have to forecast what the bank will do, not what we think they should do necessarily,” Grantham stated. “And it seems to me that they’re erring on the side of doing too much rather than too little, with the knowledge that they can always cut interest rates next year if the economy slows down more than anticipated.”
Accompanying the rate announcement on Wednesday, the central bank will release a fresh forecast for economic growth and inflation.
