The 50 basis point increase in the target rate, to 1%, testifies to the Bank of Canada’s desire to speed up its fight against inflation that is ever more widespread and persistent than Vladimir Putin’s war against ukraine only stirs things up. The central bank evokes the risk of a spiral that would feed a deanchoring of inflationary expectations.
“Russia’s unprovoked invasion of Ukraine”—to use the Bank of Canada Governor’s phrase—adds a major new source of uncertainty to the global outlook and fuels already high inflation, as the he Canadian economy has entered a phase of excess demand. In short, we must step up the pace in the fight against a surge in prices which is becoming widespread and which could degenerate.
The Bank of Canada notes that approximately two-thirds of the components of the Consumer Price Index (CPI) show growth exceeding 3%. She recalls that in February, the rise in the CPI reached its highest level in 30 years, at 5.7% over one year. Behind this average, inflation for goods reached 7.6%, a rate twice that of inflation for services. For their part, energy and food inflation stood at 24 and 7.4% respectively.
“Core inflation measures have all risen as price pressures become more widespread. The Bank now expects CPI inflation to average nearly 6% in the first half of 2022 and to remain well above the inflation-control range throughout year. It is then expected to decline to around 2.5% in the second half of 2023 and return to the 2% target in 2024, the report reads. Monetary Policy Report released Wednesday.
The central bank therefore had to revise its inflation forecast upwards, by 1.1 percentage point in 2022 and 0.5 percentage point in 2023, to 5.3% and 2.8% respectively, the adjustment being mainly related to the war in Ukraine. It now expects the effect of supply chain disruptions, reducing supply, to dissipate by mid-2023, two quarters later than it forecast at the start of the year.
The ultimate weapon for tackling inflation, the overnight rate, will therefore be put to great use. Added to this is the reduction in the size of the central bank’s balance sheet, inflated by the monetary easing applied during the pandemic. On April 25, the Bank of Canada will switch from the reinvestment phase to quantitative tightening mode. It will then cease to replace Government of Canada bonds that mature.
An increase in rates revised upwards
In terms of the cost of money, the bank is revising upwards its estimate of the so-called neutral rate, i.e. the interest rate compatible with production that remains permanently at its potential level and an inflation rate that remains at target. Its estimate is now between 2 and 3%, against 1.75 and 2.75% at the start of the year. If we take the middle of the range as a target, this neutral rate now goes to 2.5% against 2.25% previously.
“If demand responds quickly to higher rates and inflationary pressures ease, it may be appropriate to temporarily halt our tightening once we get closer to neutral, and take stock. On the other hand, we may need to raise rates a little above the neutral rate for a while in order to restore the balance between supply and demand and bring inflation back to target,” she cautions. ‘to warn.
Thus, at the start of the year, the moderate scenario, dominating among analysts, outlined four increases of 25 points this year, pushing the Bank of Canada’s key rate to 1.25%. Two additional increases were to follow in 2023, with the expected achievement of the so-called neutral rate by mid-2024 at the latest. The more aggressive scenario was then based on six increases in 2022, pushing the key rate to 1.75% in December, with the achievement of the neutral rate somewhere in the first half of 2023. Even this last projection now appears timorous, analysts now see the key rate reaching 2% by the end of the year.
Especially since the Bank of Canada is talking about the growing risk that expectations of high inflation will take root. “Labour markets are tight. Employment rose strongly, regaining more than the ground that had been lost due to the effects of the omicron variant of the coronavirus. Labor shortages are widespread, accelerating wage growth. A wide range of indicators suggests that excess capacity has been absorbed and that the economy is entering a phase of excess demand. In the face of robust demand and supply constraints, companies are raising prices to reflect the higher cost of inputs,” she writes.
Rising inflation expectations could, in turn, lead to more generalized growth in labor costs and inflationary pressures, and thus exert a lasting influence on inflation that could generate a wage-price spiral that could to unanchor inflationary expectations of the 2% target.