The Bank of Canada has raised its key interest rate for the first time since slashing the benchmark rate to near-zero at the start of the COVID-19 pandemic, in a bid to tackle inflation rates that are likely to keep rising from their current three-decade high.
The central bank increased its key rate by a quarter of a percentage point to 0.5 per cent on Wednesday in a bid to help fight inflation, which is at its highest level since 1991.
The move prompted Royal Bank and TD to raise their prime lending rates – and other big banks were expected to follow – to increase the cost of loans such as variable-rate mortgages that are linked to the central bank's benchmark rate.
In making its announcement, the Bank of Canada said it expects inflation to be higher in the near-term than previously thought. The central bank warned that this week's rate hike won't be the last, with economists expecting multiple increases before the end of the year.
Rate hikes in the past took place before the economy hit its full potential and inflation went up, said TD chief economist Beata Caranci. But circumstances are the opposite now, she said, raising the pressure on the bank to get right the timing and pace of hikes.
“They have actually less wiggle room because we are in a high-inflation environment and they weren't proactive as they were in past cycles,” she said.
“On the flip side, if things go horribly from an economic perspective, they don't have room now to cut because we're not at a level where they could give back stimulus.”
It was two years ago this week that the Bank of Canada first cut its key policy rate to get ahead of economic fallout from the emerging novel coronavirus crisis. What followed were two more rate cuts in March 2020 that brought the key policy rate to 0.25 per cent
Since then, the economy has bounced back quickly.
Statistics Canada said Tuesday that the economy grew at an annual rate of 6.7 per cent over the last three months of 2021, which was stronger than the Bank of Canada had expected, and real gross domestic product is now above pre-pandemic levels.
The bank said it expects growth in the first quarter of this year to be more solid than its previous projections in January, even with an Omicron-related setback that month that saw 200,000 jobs lost.
It expects the labour market setback to be temporary, and strong household spending should strengthen further as public health restrictions ease as several provinces have started to do this month.
Adding to existing inflationary pressures is Russia's unprovoked invasion of Ukraine, which has sent global oil prices higher and added new kinks to global supply chains.
In response, Industry Minister François-Philippe Champagne told reporters on Parliament Hill that he has asked the Competition Bureau to keep an eye on prices at the pumps, and spoken to companies about boosting domestic production to counteract any possible shortages.
Even though the bank can't specifically fight inflation linked to the conflict, it can tackle domestic price increases like those in the country's housing market, said Royce Mendes, managing director and head of macro strategy at Desjardins.
The bank hopes that by making it more expensive to borrow, demand from buyers will cool.
“These are the types of inflationary pressures that the Bank of Canada can contain with increasing its interest rates and that's what it's trying to do,” Mendes said.
Unlikely to affect housing market
The first rate hike may have the largest effect on how households manage their debt, but the central bank would have to raise rates by a full percentage point before there is an effect on the country's housing market, said BMO chief economist Douglas Porter.
“Every single basis point matters to somebody out there,” Porter said. (A basis point is a one-hundredth of a percentage point.)
“We'd need to see a number of Bank of Canada interest rate hikes before it would really begin to seriously affect the economy.”
A rate hike generally takes as little as six months or as many as 18 months before it has an effect on headline inflation.
Of more immediate concern for the bank's senior decision-makers, and noted in Wednesday's announcement, is that Canadians are starting to expect that inflation will stay higher for longer, which could lead to runaway inflation.
“In this sense, inflation expectations cause inflation,” said Tu Nguyen, an economist with RSM Canada. “So the bank taking actions and taking on a hawkish tone can help, in a way, reassure consumers and businesses to know that this bout of high inflation is not going to last forever.”