The Bank of Canada is holding, but make no mistake, rate hikes are coming

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The Bank of Canada declared an end to the economic emergency caused by COVID-19, and promptly pivoted to confront the most serious inflation scare in more than three decades.

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The central bank concluded the output gap, the difference between actual gross domestic product and the level of GDP that central bankers associate with Canada’s non-inflationary speed limit, has closed ahead of schedule thanks to “robust” hiring, exports and investment. That’s the equivalent of the Bank of Canada declaring “mission accomplished.”

Governor Tiff Macklem and his six deputies opted to end their commitment to keep the benchmark interest rate near zero until at least the spring, suggesting they will raise interest rates for the first time in more than two years when they next update interest-rate policy in early March.

“While COVID-19 continues to affect economic activity unevenly across sectors, the Governing Council judges that overall slack in the economy is absorbed, thus satisfying the condition outlined in the Bank’s forward guidance on its policy interest rate,” policy-makers said in a statement at the end of their latest round of deliberations on Jan. 26. “Looking ahead, the Governing Council expects interest rates will need to increase, with the timing and pace of those increases guided by the bank’s commitment to achieving the (two per cent) inflation target.”

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The central bank’s crisis-fighting efforts — backed by unprecedented fiscal stimulus on the part of the federal government — were remarkably successful in achieving its primary goals: crushing the deflationary forces that were triggered by the early stages of the pandemic, and then avoiding a slow recovery such as the one that followed the Great Recession.

The Bank of Canada’s new quarterly economic outlook predicts GDP accelerated to an annual rate of 5.8 per cent in the fourth quarter, enough momentum to push through headwinds caused by the Omicron variant of COVID-19 and still produce growth of about two per cent in the current quarter.

Some economists think the Bank of Canada’s recession fight has been too successful. Ahead of the policy announcement, prices of financial assets linked to short-term interest rates implied traders were betting on an immediate interest-rate increase, not a promise to do one within a couple of months.

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The consumer price index (CPI) surged 4.8 per cent in December from a year earlier, the biggest increase since 1991, which is when the Bank of Canada adopted a commitment to use the CPI to guide its interest-rate setting. The central bank’s target is two per cent, the midpoint of a comfort zone of one per cent to three per cent. Inflation has been outside the high end of that range since April, long enough for households and businesses to start thinking it will continue to do in the future.

Many traders and economists assumed the Bank of Canada would want to disrupt that psychology immediately with a sudden interest-rate increase. “There is less flexibility to be gradual now,” said Veronica Clark, an economist at Citigroup Global Market Inc., who had predicted a quarter-point increase in January followed by three more quarter-point increases spread throughout the year.

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Clark said she found it “confusing” that the Bank of Canada would state so explicitly that the recovery is complete, and then leave the benchmark interest rate at an emergency setting of 0.25 per cent, which is about as close to zero as policy-makers think it can go.

“It seems strange to us to fail to raise rates when all the previously outlined requirements for a hike are met,” she said in a note to clients.

Clark’s confusion was shared by others, highlighting the difficulty of the decision that Macklem and his deputies had to make. If they had raised interest rates, they no doubt would have confused those analysts who thought it would be a mistake to tighten financial conditions in the middle of a wave of COVID-19 infections.

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Macklem appears to have decided to avoid feeding the panic around inflation. An interest-rate increase this week might have dented the central bank’s credibility, given it had been telling households and companies for the better part of two years that they could count on ultra-low borrowing costs until at least the middle of 2022.

“We’re trying to cut through the noise so monetary policy is a source of confidence and it’s not another source of uncertainty,” Macklem said at a press conference.

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Still, the central bank is hardly blasé about inflation. Its forecast has the CPI averaging year-over-year increases of 5.1 per cent in the first quarter before calming down over the second half as supply constraints ease. The central bank sees CPI inflation of 4.2 per cent in 2022 and 2.3 per cent in 2021.

“While the upside and downside risks to the bank’s inflation projection are viewed as roughly balanced, the upside risks are of greater concern,” the Bank of Canada said in its outlook. “Until inflation moves significantly lower, there is an elevated risk that Canadians will start to believe that inflation will stay high over the long term.”

Macklem balked at raising interest rates this week, but expect a steady march higher going forward. The next announcement is March 2.

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