The Bank of Canada is signaling that it may need to raise its policy interest rate to 3 per cent or higher to get a handle on consumer price growth and to prevent Canadians from expecting persistently high inflation.
The central bank announced its second consecutive half-point interest rate hike on Wednesday, bringing the benchmark rate up to 1.5 per cent.
Bank officials have previously said they intend to get the benchmark rate to a “neutral” level of between 2 per cent and 3 per cent relatively quickly. In a speech on Thursday, deputy governor Paul Beaudry said there is a growing probability that the bank will need to move to the top end of this range or above.
“Price pressures are broadening and inflation is much higher than we expected and likely to go higher still before easing,” Mr. Beaudry said, according to the prepared English version of a speech delivered to the Chambre de commerce de Gatineau.
“This raises the likelihood that we may need to raise the policy rate to the top end or above the neutral range to bring demand and supply into balance and keep inflation expectations well anchored.”
The Bank of Canada is in the middle of an aggressive rate-hike cycle aimed at slowing the pace of inflation, which hit a new 31-year-high of 6.8 per cent in April. On Wednesday, he said that he “prepared to act more forcefully if needed” to get inflation under control. Analysts took this to mean that the bank was open to a possible 75 basis point rate hike – which would be the biggest rate increase since the 1990s.
“When we talk about ‘more forcefully,’ obviously we’re trying to think both in terms of pace [of interest rate hikes] and level,” Mr. Beaudry said in a press conference after the speech.
“That could involve doing more moves in a row, or it could involve bigger moves. All this will depend exactly on the data that comes in. We’re not doing anything on automatic pilot,” he said.
Higher interest rates can’t do much to deal with international sources of inflation, which include persistent supply-chain bottlenecks, COVID-19 lockdowns in China, and surging commodity prices following Russia’s invasion of Ukraine.
But raising borrowing costs will dampen demand in the Canadian economy. This is important because consumer prices are increasingly being pushed up by domestic factors as demand outstrips supply in Canada’s overheating economy.
“Demand-driven domestic inflation happens when households and businesses are willing to buy more goods and services than the economy can produce. If left unchecked, it can open the door to persistently higher inflation,” Mr. Beaudry said in his speech.
The key concern for the central bank is making sure that inflation expectations don’t become unanchored. Where people think consumer prices are headed has a significant impact where they end up. Businesses set prices and employees negotiate wages based on their beliefs about inflation, which can create a kind of self-reinforcing cycle.
“The longer inflation remains well above our target, the more likely it is to feed into inflation expectations, and the greater the risk that inflation becomes self-fulfilling,” Mr. Beaudry said.
“History shows that once high inflation is entrenched, bringing it back down without severely hampering the economy is hard. Preventing high inflation from becoming entrenched is much more desirable than trying to quash it once it has,” he said.
Royce Mendes, head of macro strategy at Desjardins Capital Markets, said in a note to clients that it could be difficult for the bank to get its policy rate close to 3 per cent or above.
“The Canadian economy is extremely interest rate sensitive, which could limit the number of additional hikes needed to cool demand. With the housing market already showing signs of softening, our view is still that the Bank of Canada won’t be able to raise rates above 2.25 per cent,” Mr. Mendes wrote.
“Remember that in the last cycle the central bank told a similar story about getting rates up towards the 3 per cent range, but was only able to push the policy rate up to 1.75 per cent. At that point, the housing market and consumer spending began to weaken so dramatically that rate cuts were on the table even before the pandemic.”
Mr. Beaudry’s speech also offered the Bank of Canada’s clearest explanation to date about why it waited until the spring of 2022 to start raising interest rates. That decision has been criticized by private sector economists who say the bank was slow to begin tightening monetary policy, particularly once it became apparent in the fall of 2021 that high inflation would not be transitory.
Mr. Beaudry said the bank was weighing risks and making decisions based on how inflationary shocks had played out in the past. He said there were several reasons it held off raising rates.
For one, much of the inflationary pressure in the summer and fall of 2021 came from international forces tied to global supply chain bottlenecks and oil prices. “Inflationary shocks coming from abroad are often temporary,” Mr. Beaudry said.
“Second, for most of 2021, the economy was operating well below capacity, so there wasn’t excess demand. Finally, amid successive waves of the pandemic, we knew that premature tightening could impede the ability of people who lost jobs during the pandemic to find work again,” he said.
There was always a risk that inflation would prove more persistent than the bank anticipated, and that it would become entrenched, Mr. Beaudry said. But he said that “this risk seemed appropriate to take at the time, given the slack in the economy and the view that the supply-driven sources of elevated inflation would likely prove temporary.”
“The situation today is notably different,” he said.
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