Economic insight provided by Alberta Central Chief Economist Charles St-Arnaud
- At its October meeting, the Bank of Canada left its policy rate unchanged and ended its quantitative easing program (QE). But the main event was that it expects to start hiking rates earlier than before and stands ready to fight inflation.
- As result, financial markets have significantly repriced their interest rate expectations believing that the Bank of Canada will hike in early 2022 and increase its policy rate by 125bp over the course of the year.
- However, the inflationary pressures are mainly coming from supply issues. This means that the central bank faces a trade-off between fighting inflation and risking stalling the recovery or tolerating higher inflation to allow further recovery in the labour market.
- There are a number of factors that suggest the Bank of Canada could be cautious in its approach:
- There is still considerable slack in the labour market;
- The economy is more sensitive to higher interest rates because of high level of private debt (households and businesses) and housing affordability in many markets depends on low interest rates;
- The inflationary pressures are global and will lead to most central banks hiking rates over the next year; and
- Many of the government’s COVID support programs are being wound down, which should lead to a normalization in disposable income.
- Using previous hiking cycles by the Bank of Canada, we have updated our view of the path for monetary policy in 2022. We still expect the Bank of Canada to start hiking rates at the July meeting. However, we believe the central bank will increase its policy rate in rapid succession, bringing it to 1.00% by the October meeting.
- The risk is that the Bank of Canada could start rising rates at the April meeting, if there are signs that inflation expectations become unmoored. The timing of the first hike, April vs July, will also depend on how quickly the slack in the labour market will be removed in the coming months.
Inflation has been running above the Bank of Canada’s target range since April and is currently at its highest level since the early 2000s. At its latest monetary meeting on October 27th, the Bank of Canada brought forward the expected timing for the first rate hike and Governor Macklem said the central bank was committed to ensure there was no ongoing inflation.
As a result of the more hawkish rhetoric from the Bank of Canada, financial markets have significantly revised their views on interest rates, bringing forward the moment of the first rate hike to early 2022 and rising the amount of hikes over the course of 2022 to more than 125bp at one point. An important question is whether the central bank can be that aggressive with its monetary policy tightening.
A recap of the Bank of Canada’s meeting
Without much surprise, the Bank of Canada left its policy rate unchanged at its October 27th policy meeting and said that its quantitative easing program was entering the “reinvestment phase.” i.e. it will purchase only government bonds to replace maturing ones, therefore keeping the size of its government holding unchanged (see Bank of Canada Ends Qualitative Easing for our views at the time). The main surprise for many investors was the change to the central bank’s forward guidance, with the Bank of Canada now expecting to raise its policy rate in the “middle quarters of 2022,” sooner than previously stated. Moreover, Governor Macklem also sounded more hawkish at the press conference saying that “it is our job to bring inflation back to target, and I can assure you we will do that.”
We make the following observations:
- By saying that “it should keep the size of its balance sheet unchanged until at least the first rate hike.” the Bank of Canada makes it clear that it prefers to reduce the amount of monetary stimulus via the price of money channel, i.e. interest rates, rather than the quantity of money channel, i.e.bond holding. This shouldn’t be surprising; central banks have been using interest rates for the past four decades to adjust the level of monetary stimulus in the economy. Therefore, they have a much better understanding of its impact of interest rates on the broader economy than quantitative easing, which is newer and less fully understood.
- The choice of wording for the new forward guidance is intriguing. It is the first time in memory that the Bank of Canada refers directly to specific quarters in saying the middle quarters of 2022. Usually, it would have said mid-2022 or, as previously used, the second half of 2022. We believe that this wording may have been decided to provide some extra flexibility, as the mid quarters of 2022 would include the April and the July meeting, since we believe the Bank of Canada is likely to start hiking at a meeting where it will update its forecast. Simply saying mid-2022 would likely only encompass the July meeting.
- The comment for Governor Macklem that the Bank of Canada will stand ready to act against inflation is likely aimed at keeping inflation expectations from increasing. The central bank understands that rising interest rates too soon or too quickly could stall the recovery. While we believe the Bank of Canada is likely to use some flexibility to allow the economy to recovery further, this flexibility could disappear rapidly if inflation continues to increase and/or if inflation expectations become unmoored.
This time is different: demand vs supply shock
As we wrote previously (see Pep Talk for Central Bankers and Supply-Induced Inflation), the nature of the shock affecting the economy is very different this time around than during previous episodes of rising inflation. Previous increases in inflationary pressures and recessions were mainly the result of demand, which are easier to control with monetary policy. However, we are the midst of an inflationary period driven by a supply shock. As a result, to reduce inflationary pressures, central banks need to create some slack in the economy; in other words, generate weaker economic activity and lower employment to compensate for the inflationary pressures due to the supply shock. This creates a dilemma for central banks: bringing inflation down at the expense of employment or tolerating higher inflation to allow further recovery in the labour market.
The latest policy statement from the Bank of Canada shows indirectly how these factors are influencing the central bank’s thoughts. It continues to see that “slack remains in the overall labour market,” while simultaneously adding that “the output gap is likely to be narrower than the Bank had forecast in July” because of the supply shock. Overall, it seems the Bank of Canada is also in the camp that most of the inflationary pressures, i.e. the narrowing of the output gap, is the result of supply factors, not demand.
How much hiking can the Bank of Canada do?
Financial markets currently expect the Bank of Canada to increase its policy rate by about 125bp, the equivalent of five 25bp hikes, over the course of 2022. As seen previously, given the trade-off between inflation and economic activity in the case of a supply shock, this situation raises the question as to whether the Bank of Canada can be that aggressive in removing its monetary stimulus and risking stalling the recovery or even cause a recession.
Here are some reasons the Bank of Canada is likely to be less aggressive than currently expected by the market:
- There is still a lot of slack in the labour market, as acknowledged by the Bank of Canada. First, the employment rate, the share of working-age population in employment, is still about 1 percentage point (pp) below its pre-pandemic level at 61%. Employment would need to rise by about 310,000k workers at the current level of working-age population to normalize the ratio. Second, the unemployment rate is about 1pp above its pre-COVID level, meaning there are about 220k more unemployed workers compared to the start of 2020. Third, the under utilization rate, the share of the labour force that is either unemployed or working less than they would want, is still about 1.5pp higher (about 270k workers) than it was pre-pandemic. Fourth, the average unemployed person has been out of work for about 25 weeks, the highest since the late 1990s. Similarly, the proportion of workers that have been unemployed for more than 27 weeks has not been this high since the mid-1990s. The longer those workers remain out of employment, the more skills they are losing and will suffer long-term consequences in terms of income and employ-ability.
- The Canadian economy is one of the most leveraged economies in the G20, based on private debt (households and businesses). This means that each rate hike will have more impact on economic activity than it had in the past, as households and businesses will need to divert an increasing share of their income to debt repayment. The experience in 2017, when the Bank of Canada last started a hiking cycle, is telling, as retail sales in volume flat lined as soon as the Bank of Canada started hiking rates.
- There are also some concerns regarding the housing market. We estimate that some cities like Toronto, Ottawa and Montreal could become unaffordable with a 100bp increase in interest rates (see Rising Interest Rates to Make Many Canadian Cities Unaffordable). While it may not lead to a collapse of these markets, it would likely have some headwinds on consumer spending.
- The supply shock and inflationary shock is global. As a result, most central banks in the world are expected to reduce the amount of monetary stimulus in their economy. Taken in isolation, each action shouldn’t be of concern. But one needs to wonder what a coordinated global tightening of monetary policy will do to the global economy and what will be the impact on Canada’s export performance and growth as a result.
- With the pandemic subsiding, government support programs are being gradually phased out, starting with some income-replacement programs that are becoming much less generous than before. The COVID recession was unusual in the fact that disposable income increased while unemployment rose. The reduction in those programs with lead to a normalization in disposable income and will be a headwind to growth.
- If the supply shock proves to be temporary, as expected by many analysts and the Bank of Canada, the supply-induced inflationary pressures will subside at that point. This could mean the Bank of Canada may need to reverse course and cut rates in 2023 to fight the deflationary impact of the normalization of the supply side.
All those factors push for some caution in increasing interest rates to fight inflation, as the economy may slow more than expected. The risk is that, by being as aggressive as the market is currently pricing in, the central bank could stall the recovery and may need to reverse course in 2023, when some of the inflationary pressures start to ease – either because of a reversal in the supply shock or because of excessive slack created by the monetary tightening.
What to expect from the Bank of Canada?
As a start, it may be useful to look at recent hiking cycles by the Bank of Canada to assess whether there could be a pattern. We will only consider the latest two episodes, 2010 and 2017, as in both cases rates were at – or very close to – the lower effective bound.
- In 2010, the Bank of Canada started to increase its policy rate starting in May of that year, with 25bp. It continued to increase the policy rate by 25bp at the next two meetings, before leaving rates unchanged at 1.00% for about four years.
- In 2017, the central bank started to hike rates at the July meeting and again at the September meeting. It left the policy rate at 1.00% until January 2018 when it hiked 25bp and again at the July and October meetings, ending the year at 1.75%.
Based on previous experiences, we make the following observations:
- The Bank of Canada tends to increase its policy rate rapidly at the initial stage of the tightening cycle, hiking by 25bp at successive meetings.
- The central bank tends to take a pause or slow the pace of tightening once the policy rate reaches 1.00%.
- The Bank of Canada seems to prefer to hike at meetings that coincide with the release of the Monetary Policy Report. This could be because of the additional background on the economic outlook the report provides. Moreover, the fact that the Bank of Canada’s Governor holds a press conference also allows for another opportunity to clarify the decision and provide further guidance to market participants.
Based on our current view of the economy and the observations above, we continue to believe the Bank of Canada will start its tightening cycle at the July 2022 meeting by hiking by 25bp. We believe the central bank will use some flexibility in its fight against inflation to support further recovery in the labour market.
However, we believe that the rise in the policy rate will be faster than previously forecasted. As such, we now believe the Bank of Canada will hike in rapid succession, increasing rates at the September and October meetings, bringing the policy rate to 1.00% by year-end. After reaching this level, the Bank of Canada will hike its rate by 25bp in January 2023, but slow the pace by rising again in April and July, with the policy rate reaching 1.75% by end-2023.
The risk to this view is that the Bank of Canada could be more aggressive than expected, especially if inflation expectations were to increase or if the slack in the labour market was to disappear more rapidly. This could lead to the first rate hike at the April meeting, but this would likely be the earliest. If it were the case, we believe the Bank of Canada would still increase its policy rate in rapid succession by also hiking at the June and July meetings to 1.00%. In this scenario, there is a risk the Bank of Canada would likely hike again before the end of the year, bringing the policy rate to 1.25% by end-2022.
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