The road is slippery and visibility is poor. So as not to rush into the background, the Bank of Canada will cautiously negotiate the shift in its monetary policy, as it announces on Wednesday the first of four or five key rate hikes this year. This scenario should be taken with a grain of de-icing salt, because the Bank does not decide anything in advance.
Posted yesterday at 10:00 a.m.
At 5.1%, inflation is at its highest in 30 years, well above the 2% target. Unfortunately, there is nothing the Bank can do to curb the current inflation. Rate changes take 18 months to two years to take full effect.
The announcement of the first increases of 25 basis points (100 points equal 1%) will above all have a psychological goal: to show that the Bank is determined to curb inflation. Governor Tiff Macklem wants to prevent it from becoming embedded in people’s minds and lastingly changing behavior.
Consumer and business surveys, as well as the interest rate futures market, still reflect expectations of a return to 2% inflation in the medium term. However, persistent inflation could unanchor these expectations and soar quickly.
The situation is more complicated than in past economic cycles, as current inflation is largely driven by global supply-side factors, over which the central bank has no control and which could take quite a long time to set in. dispel.
Consider bottlenecks in global supply chains. China, the world’s largest workshop, maintains a tough zero COVID-19 policy because its vaccines are powerless against variants. Its factories, its ports, even entire cities can be closed for a handful of cases.
Supply that is not sufficient to meet demand will eventually adjust, but this could take time and result in higher costs being passed on to customers. For example, the two microprocessor factories Intel is building in Ohio that will go into production in 2025.
The Bank is also helpless in the face of sharp increases in the energy sector prompted by Russian aggression in Ukraine, greater discipline by US shale oil producers and a laborious transition to renewable energy.
It is just as helpless in the face of climate change, which devastates crops and drives up food prices. Nor can it do anything about US inflation, which seeps in through cross-border trade.
The Bank of Canada’s only lever, interest rates only have an effect on demand. And even.
The rate hikes will have a limited impact on the behavior of consumers frustrated by the constraints of the pandemic and spoiling themselves in stores before heading back on vacation. This pent-up demand is fueled by the savings accumulated over the past two years, especially among people who have kept their jobs or whose losses have been compensated by government assistance.
It is mainly the housing sector that will be hit by the rate hikes, in particular potential first-time buyers, put off by higher monthly payments, as well as homeowners who will have to tighten their belts when renewing their mortgage.
We should also see a sharp decline in public deficits, which have boosted the economy for two years. But let’s wait to see the spring budgets to take the measure of the necessary relaxation of the budgetary stimulus.
Finally, it will be necessary to monitor the evolution of wages in a context of labor shortage, where the balance of power now favors employees.
But the big question for the Bank is to know at what level of interest rate it will obtain the desired moderation of demand. The answer, which no one knows, will appear gradually in economic indicators such as housing starts, hence the need for gradual increases punctuated by pauses to analyze a changing situation.
From quantitative easing to quantitative tightening
Last November, the Bank of Canada ended the massive purchase of federal government bonds, but is still replacing those that come due. Their balance sheet weight has more than quadrupled in two years. This week, we expect indications of their upcoming gradual reduction, not replacing all the titles that have expired.
Our central bank will not be alone in raising its key rate and carrying out quantitative tightening. The Fed will do the same in March and other central banks have already started to tighten their monetary policy.
Many financiers think that they have fallen behind, that we must catch up quickly, especially in the United States. We can see it in the North American bond market, which anticipates six to seven increases this year, bringing key rates to at least 2%. It is not impossible, but the economists of the Canadian banks are rather of the opinion that there will be fewer of them here, four or five.
These same banks foresee one or two more last increases in 2023, for a cyclical peak of the key rate at 2.25%. We’ll see, because a lot of things will change between now and then.
An important unknown is the effect that the increase in rates will have on the value of financial assets and on real estate, which have benefited enormously from the low level of rates and abundant liquidity: a simple stock market correction, as at the moment ? Or a longer down cycle? Will central banks feel compelled to save the skin of investors to preserve the stability of the financial system?
Will we see an inversion of the yield curve, where short-term interest rates rise above long rates, the classic (but not infallible) harbinger of a recession?
Despite a tangled crystal ball, the Bank of Canada must raise the cost of credit to keep inflation from racing. However, it must avoid too rapid or too numerous increases, which would plunge the economy into recession, without crushing inflation which partly escapes it. It will need a lot of tact to avoid a scenario of stagflation.