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Kevin Carmichael: 100bp hike shows public serious about reining in price pressures
Publication date:
July 13, 2022 • 12 minutes ago • 5 minutes read • 11 comments Bank of Canada Governor Tiff Macklem. Photo by Blair Gable/Reuters
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The Bank of Canada dealt a blow to Bay Street by raising its benchmark interest rate by a full percentage point, the largest single increase since August 1998, when the central bank was struggling to protect the currency’s value during the Asian financial crisis.
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Canada’s benchmark lending rate is now 2.5 percent, down from 1.75 percent before the post-Covid-19 recession. The aggressive move is all about inflation, which the Bank of Canada predicts will accelerate to about eight percent this summer, too fast for policymakers whose job it is to keep the consumer price index advancing at an annual rate of about two percent.
“Surveys show that more consumers and businesses expect inflation to be higher for longer, raising the risk that higher inflation will become entrenched in prices and wage determinations,” the Bank of Canada said in a statement. “If that happens, the economic cost of restoring price stability will be higher.”
Here’s what you need to know:
Panic movement
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Gov. Tiff Macklem’s policy team barely tried to hide its dismay at the latest data, which suggests companies and households are beginning to see inflation as permanent.
“With the economy clearly in excess demand, inflation high and expanding, and more consumers expecting high inflation to persist for longer, the Governing Council decided to begin the path to higher interest rates by raising the key rate by 100 basis points today,” the Bank of Canada said in a statement.
Central bankers are having nightmares about the public losing faith in their ability to keep inflation low and stable. Most believe that one of the lessons of the 1970s and early 1980s is that suppliers and workers will not overreact to temporary spikes in commodity prices if they believe the central bank will contain inflation.
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However, it has been four decades since Canadians have seen inflation like they did in 2022. Macklem came of age as an economist while former United States Federal Reserve Chairman Paul Volcker was winning his war on inflation by raising interest rates to double digits. The Canadian decided a show of his own resolve was needed to avoid a repeat of the painful recession caused by Volcker’s strategy.
More are coming
The Bank of Canada estimates the “neutral” interest rate — a theoretical setting where the central bank’s benchmark interest rate neither helps nor hinders economic growth — is between two percent and three percent. Interest rates are now in that zone, but policymakers have made it clear they are not done.
“The Governing Council continues to assess that interest rates will need to rise further and the pace of increases will be guided by the Bank’s current assessment of the economy and inflation,” the statement said. “The Governing Council is resolute in its commitment to price stability and will continue to take the necessary actions to achieve the two percent target.”
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The Governing Council continues to assess that interest rates will need to rise further
Macklem said earlier that he may need to raise the benchmark interest rate above three percent to tame inflation. As prices accelerate in the second half of the year, rather than decelerate, it becomes more likely that policymakers will need to push interest rates to a level that hinders economic growth.
The new perspective
The decision to “front-load” the move to higher interest rates was based on an updated quarterly forecast that would have startled Macklem and his deputies when staff economists presented it. Here are the highlights:
Inflation
The central bank sees an annual increase in the consumer price index averaging eight percent in the third quarter and ending the year at 7.5 percent higher than at the end of 2021, up from a previous estimate of 4.5 percent. The Bank of Canada now assumes that the consumer price index will still be above three per cent at the end of 2023 (compared to a previous estimate of 2.4 per cent). The central bank’s forecast sees inflation returning to target in 2024.
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Growth
Higher interest rates and higher costs are starting to bite. The Bank of Canada forecasts gross domestic product will grow 3.5% in 2022, down from an April forecast of 4.2%, and then slow to 1.8% in 2023, down from 3.2% before that. That would be what economists call a “soft landing” from the shock of higher interest rates, and Macklem would have staged an impressive maneuver if he could pull it off. In the past, sharp increases in borrowing costs have tended to trigger recessions.
Illumination of moons
Few, if any, on Bay Street saw a full one-point increase. Most thought the Bank of Canada would follow the Fed and raise the benchmark interest rate by three-quarters of a point.
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Macklem and his deputies had an incentive to outdo the Fed. Usually, higher oil prices lead to an increase in the value of the Canadian dollar. But for some reason the exchange rate is roughly stable even though international oil prices have soared above US$100 per barrel. This contributed to inflation because a weaker currency made imports more expensive.
An important factor in determining exchange rates is the difference in interest rates between different central banks. By becoming bigger than the Fed and other major central banks, the Bank of Canada will force traders to rethink the values they assign to different currencies. The moon should get a boost that will lean against inflation — at least until the next Fed meeting, when Chairman Jerome Powell will have to confront his own inflationary threat.
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The apartment is starting to hurt
“There is a sharp slowdown in the housing market,” the Bank of Canada said in its new quarterly economic outlook.
Real estate is perhaps the most sensitive industry to interest rates. Demand and prices soared when Canada’s central bank cut its benchmark interest rate to near zero, and now the bubble in markets like Toronto is quickly deflating as borrowing costs rise.
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Bank of Canada raises interest rate: Read the official statement
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What the Bank of Canada’s full percentage point increase means for the housing market and your mortgage
The biggest change in the Bank of Canada’s forecast for economic growth is its outlook for housing’s contribution, which it now sees subtracting 0.7 percentage points from gross domestic product in 2022 and subtracting an additional 0.6 percentage points from the calculation of GDP in 2023 (The April estimate shows housing subtracting 0.2 percentage points from GDP in 2023)
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Five-year fixed mortgage rates are now at their highest in more than a decade.
Bottom row
Central banks have spent the last decade thinking about the extent to which they tested the old links between employment and inflation because there was plenty of evidence that they could probably run their economies more hotly than they thought. Still, price stability remained the primary mission, and with it now clear that inflation was not slowing down on its own, the Bank of Canada decided to undertake a shock and awe-inspiring hike to show the public that it was serious about keeping price pressures under control .
Recent data showed that companies and households are starting to factor expectations of higher inflation into what they charge for goods and services and what they expect to be paid for their labor. This risks an inflationary spiral that would require stopping a recession. By acting aggressively now, policymakers hope they are averting a bad outcome.
• Email: kcarmichael@postmedia.com | Twitter: Carmichael Kevin
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