Bank of Canada targets inflation expectations with full percentage point rate hike

economy

The Bank of Canada signaled a more aggressive approach to bringing skyrocketing inflation back under control as it hiked its key interest rate by a full percentage point on Wednesday, marking the largest single rate increase since August 1998.

The central bank's governor, Tiff Macklem, said the oversized rate hike reflected "very unusual economic circumstances."

"Inflation is too high, and more people are getting more worried that high inflation is here to stay," he said.

"We cannot let that happen. Restoring price stability – low, stable and predictable inflation – is paramount."

Most economists had forecasted a rate hike of three-quarters of a percentage point.

Wednesday's rate hike brings the Bank of Canada's target for the overnight rate to 2.5 per cent and is expected to prompt commercial banks to raise their prime rates, which will increase the cost of loans linked to the benchmark such as variable rate mortgages and home equity lines of credit.

Macklem said higher interest rates will add to the difficulties that Canadians are already facing with high inflation but that if inflation becomes entrenched it will be more painful for the economy – and for Canadians – to get it back down.

"I think the larger-than-expected move really underscores how worried the bank candidate is above the inflation outlook," said BMO senior economist Sal Guatieri.

In terms of impact, Guatieri said this supersized hike will "cool the housing market even further." Activity in the housing market has already been on the decline as interest rates have climbed in recent months. In May, home sales had dropped nearly 22 per cent since a year ago.

The Bank of Canada maintains that global factors are the major drivers of inflation seen here in Canada but says "domestic demand pressures are becoming more prominent."

Domestically, Canada's central bank said "further excess demand has built up," allowing businesses to pass more of their cost increases on to consumers.

Labour markets are also exceptionally tight, with the unemployment rate falling to a record-low of 4.9 per cent in June.

A major concern domestically for the Bank of Canada is rising inflation expectations among consumers and businesses, as evidenced by the recent findings of the central bank's consumer and business outlook surveys.

Economists generally worry when people begin expecting high inflation, as those expectations then feed into future prices set by business and wage negotiations.

Guatieri said while global conditions are not within the control of the central bank, inflation expectations are within its influence.

At the same time, fears have been bubbling as to whether the Bank of Canada's moves to raise interest rates quickly could lead to a recession.

In a recent analysis published by the Canadian Centre for Policy Alternatives, economist David MacDonald warned that rapidly increasing rates would likely trigger a recession that could cause "collateral damage."

An RBC report released last week also said Canada is heading for a `"moderate" recession that will be short-lived.

On Wednesday, Macklem acknowledged that the path to a "soft landing" – which refers to a decline in inflation without significant impact on economic growth – has "narrowed."

"That is an important reason why we took stronger action today to front-load the policy interest rates," he said.

Guatieri said that with front-loading the policy rate, it has two opposing impacts by blunting economic growth more greatly but keeping inflation expectations steady.

"We think it's about a coin flip as to whether Canada slips into an official recession," said Guatieri.

Tu Nguyen, an economist with accounting and consulting firm RSM Canada, said although Wednesday's rate announcement may have come as a surprise, it wasn't unreasonable given the rate of inflation, rising inflation expectations and the tight labour market.

"As unsettling as this news is for consumers and businesses alike, an economy-wide recession is still unlikely in 2022," said Nguyen.

In its forecast, the Bank of Canada said it expects GDP growth to begin to slow this year, growing by 1.75 per cent in 2023 and 2.5 per cent in 2024.

The central bank's projections assume that globally, oil prices will gradually decrease, and supply chain disruptions will ease.

It's also forecasting inflation will remain at eight per cent over the next few months and begin to decline toward the end of the year and reach its target rate of two per cent by the end of 2024.

Inflation in Canada hit a 39-year-high of 7.7 per cent in May.

When asked about the likelihood of a recession as rates climb while appearing at an unrelated event on Wednesday, Prime Minister Justin Trudeau said ``there are global pressures at play'' and that Canada would work with global partners to prevent an economic downturn.

Meanwhile, in the U.S., inflation soared to a new four-decade peak in June. Consumer prices rose 9.1 per cent compared with a year earlier, the government said on Wednesday.

Statistics Canada will release Canada's inflation data for June on July 20.

The Bank of Canada's next rate announcement is set for Sept. 7.

"The governing council continues to judge that interest rates will need to rise further," the Bank of Canada said in its decision on Wednesday, adding that the pace of these rate hikes will depend on the central bank's assessment of the economy and inflation.

BMO is forecasting a half-percentage point rate hike in September, followed by two hikes by a quarter of a percentage point, bringing the overnight rate to 3.5 per cent by the end of the year.