The Bank of Canada chooses its second in command.
Last week’s strong jobs data pretty much guarantee the Bank of Canada will reduce its purchases of Government of Canada bonds when it makes its interest rates announcement on Wednesday, but Governor Tiff Macklem probably would have been inclined to do so even if the hiring number hadn’t exceeded expectations.
Macklem and his four deputies began their interest-rate deliberations last week with some good news. The central bank’s latest Business Outlook Survey (BOS) suggests executives are preparing for a burst of demand as soon as health restrictions ease. The quarterly poll also flagged some emerging inflation risks, which argues in favour of taking advantage of windows to reduce monetary stimulus, just in case worries about price increases become entrenched.
Overall business sentiment, which the Bank of Canada calculates by amalgamating answers to core questions into a single index, rose to its highest on record. “No firms reported signs of a deterioration in demand,” the report said.
To be sure, some 40 per cent of respondents said current sales were weaker than a year earlier, and companies “hardest hit” by the pandemic doubt that sales will recover to previous levels over the next 12 months. So to a certain extent, current optimism is a product of how terrible things were a year ago. With vaccinates rates climbing quickly, it can only get better.
The traumatic collapse of the economy in the spring of 2020 is causing a mismatch in supply and demand now. Companies prepared for the worst, firing workers and freezing investment. But unprecedented emergency benefits cushioned the decline, leaving households with money to spend. So demand is coming back stronger than companies’ ability to supply it. Expectations of upward pressure on wages are near the highest on record, and predictions of higher prices remained at elevated levels for the third consecutive quarter.
Thirty-five per cent of respondents said they expected inflation would exceed three per cent over the next 12 months, compared with 13 per cent in the previous survey. Executives haven’t been this skeptical of the Bank of Canada’s ability to keep prices from breeching the high end of its comfort zone since the early days of the Great Recession in 2008.
Still, about half of respondents said they thought inflation would hold between two per cent and three per cent, an increase from the previous quarter, suggesting the Bank of Canada has successfully avoided deflation, which was its primary concern a year ago. A similar number of firms reported that they expected their prime rates of interest would increase over the next two years.
That’s a reasonable expectation. The Bank of Canada’s
TO A CERTAIN EXTENT ... OPTIMISM IS A PRODUCT OF HOW TERRIBLE THINGS WERE A YEAR AGO.
current guidance is that it will leave the benchmark rate pinned near zero at least until the second half of next year, which is when Macklem has said he will start thinking about adjusting his main policy lever.
But borrowing rates likely will drift higher over the interim as the central bank edges out of the bond market. In April, the central bank dropped its weekly purchases of federal debt to $3 billion, and it likely will decide to shave its bond-buying program to at least $2 billion this week. The data are too strong to justify so much stimulus.
The Bank of Canada is in a tricky spot, though. Macklem and his deputies are confident the burst of inflation this spring is temporary, but they can’t assume they are correct. At the same time, if they hedge against price increases too aggressively by reducing stimulus, they risk smothering a recovery that is still well short of Macklem’s goals.
In all likelihood, the central bank will err on the side of growth. Before she resigned at the end of last year, Carolyn Wilkins, the former senior deputy governor, said the Bank of Canada could consider “probing” the limits of its inflation mandate, an acknowledgment that the central bank’s fixation with its two-per-cent target might have come at the expense of achieving full employment.
Employment is Macklem’s his primary goal for now. Don’t be surprised if he’s willing to stomach a little more inflation in order to achieve it.