Bank of Canada raises interest rates
OTTAWA — The Bank of Canada delivered what it expects to be its last interest rate hike of the cycle as it pauses to assess the effects of higher rates on the economy.
The central bank raised its key interest rate by a quarter of a percentage point Wednesday, marking the eighth consecutive hike since March in the face of decades-high inflation.
Its key interest rate now stands at 4.5 per cent, the highest it’s been since 2007.
In a news release, the Bank of Canada said the Canadian economy is still overheated, prompting its governing council to raise interest rates once again.
However, if economic developments stay in line with its current projections, the central bank said it expects to hold its key interest rate at its current level.
“To be clear, this is a conditional pause,” Governor Tiff Macklem said at a news conference Wednesday.
“If we need to do more to get inflation to the two per cent target, we will.”
TD director of economics James Orlando said the Bank of Canada had to keep the option of raising rates again on the table so that financial conditions remain tight and spending is restrained.
The rate hike Wednesday comes after months of inflation slowing in Canada. After peaking at 8.1 per cent in the summer, the country’s annual inflation rate has steadily declined and reached 6.3 per cent in December.
The Bank of Canada also published its latest monetary policy report Wednesday, providing updated projections for the economy and inflation.
According to the report, the central bank expects inflation to slow faster than it had previously anticipated. It’s forecasting the annual inflation rate will fall to three per cent by mid-2023 and to its two per cent target in 2024.
The slowdown in inflation has been attributed to declines in energy prices as well as easing in global supply chain disruptions.
Orlando said economists are becoming more confident that inflation will in fact slow considerably this year.
“Everything is in place for inflation to continue to decelerate,” he said.
At the same time, the labour market is still tight and inflation expectations among businesses and consumers are still elevated, the central bank said.
Statistics Canada’s latest labour force survey revealed unemployment in Canada is near historical lows, with the unemployment rate at five per cent in December.
While the Bank of Canada has previously raised concerns about strong wage growth potentially feeding into inflation, it now says risks around a wage-price spiral have declined as wage growth has plateaued.
In the months to come, higher borrowing costs are expected to slow activity more noticeably because of businesses and consumers pulling back on spending.
As this process unfolds, the Bank of Canada projects growth in the economy will stall through the first half of the year before picking back up toward the end of the year.
After growing by 3.6 per cent in 2022, the Bank of Canada is projecting the economy will grow by a modest one per cent in 2023.
While Macklem would not comment Wednesday on when the central bank may begin cutting rates, Orlando said markets are already trying to guess.
As both the economy and inflation slow, the economist said the central bank will have to switch gears and start cutting rates.
“They have to find balance between making sure inflation comes down to a reasonable level and overtightening,” he said.
TD expects the Bank of Canada to begin slashing rates at the end of 2023.
Globally, the central bank said growth has been stronger than expected as consumers have continued to spend.
The Bank of Canada “resolutely” declared it will fight inflation by raising interest rates. To demonstrate its unwavering commitment to reaching the bank’s two per cent inflation target, today’s eighth consecutive interest rate hike brings the policy rate to 4.5 per cent.
The bank’s logic is this: when demand outpaces what the economy supplies, the result is inflation. Based on this analysis, the Bank of Canada raises interest rates to “dampen demand so supply can catch up.” Using interest rates to fight inflation has been central banks’ boilerplate approach for years.
Higher interest rates deliberately slow the economy by discouraging borrowing. In a slowing economy, labour demand eases and job vacancies decline. This is a bitter pill to swallow for those already struggling to make ends meet, since deliberately encouraging higher unemployment exerts downward pressure on wage growth.
Why does the central bank emphasize how resolutely committed it is to raising interest rates? In central banker lingo, this is called jawboning or forward guidance.
Jawboning is communication intended to influence the expectations of the public. As Ben Bernanke, former chairman of the United States Federal Reserve, once explained – when he could talk more freely after leaving the bank – “monetary policy is 98 per cent talk and only two per cent action.”
By emphasizing its steadfast commitment to lowering inflation, the Bank of Canada hopes to persuade the public to expect lower inflation.
The bank is eager to influence our expectations about inflation because expectations can be selffulfilling.
If we expect future price increases, we are likely to bid up prices (and seek higher wages) in anticipation of impending price hikes.
If the Bank of Canada convinces us that it can and will beat inflation, we are more likely to refrain from actions that bid up prices, and thereby support the bank’s fight against inflation.
But central bank influence on expectations is a double-edged sword. As Bernanke writes:
“The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has. The downside for policymakers, of course, is that the cost of sending the wrong message can be high.”
Jawboning only dampens inflationary expectations if the public has faith that the Bank of Canada is credible in its analysis and actions. But do we believe that raising interest rates is the right tool to control inflation?
As the bank itself acknowledges, there are other causes of inflation, such as the war in Ukraine and supply disruptions caused by the pandemic. These issues will not be solved by increasing interest rates.
Arguably, the public worries about many inflation causes that are beyond the Bank of Canada’s control.
For instance, Canadians may be concerned about “greedflation” that occurs when large companies exploit their extensive market power to boost prices excessively.
The recent Parliamentary inquiry and Competition Bureau study of competition among grocery stores was prompted by the possibility that food costs are impacted by this lack of competition.
The central bank has little control over many factors impacting inflation, such as extreme weather in areas that export food and raw materials to Canada. There are also longer-term supply challenges with inflationary repercussions.
Consider the future implications of the war in Ukraine and other geopolitical instability.
Globalization has been extolled for keeping costs down, but global supply chains are vulnerable to disruption by anything from the COVID-19 situation in China to ships getting stuck in the Suez Canal.
To protect supply chains, companies may onshore or “friendshore” by moving production to locations viewed as more insulated from international turbulence. This could exert upward pressure on prices if it requires building new facilities in higher-cost areas.
Climate change also influences inflation. It may reduce crop yields, for example. But fighting climate change also impacts inflation over the longer term. Living up to our climate commitments requires the transformation of energy production, manufacturing and transportation. This will be expensive.
Ironically, higher interest rates may further increase the costs of responding to climate change, localizing supply chains and other longer-term challenges.
Building new production, transportation and other infrastructure takes funding, and higher interest rates makes it more expensive to borrow money to invest in restructuring.
Given the array of publicly visible factors contributing to inflation, the Bank of Canada needs to consider the possibility that the public will not be persuaded that their approach to inflation fits these unprecedented times.
Effective jawboning requires credibility. This credibility is based on the public’s belief that the central bank is using the right tools for the job.
The Bank of Canada does not want to appear to be suffering from Maslow’s hammer – a bias against trying more appropriate tools because, as the saying goes, “if you only have a hammer, everything looks like a nail.”
Ultimately, the reputation of the Bank of Canada will be undermined if the public believes that it’s pounding away with a hammer that is not needed and causing much hardship in the process.
If the bank loses credibility, the public may conclude this hammering is preventing us from pursuing more constructive options. Paradoxically, inflationary expectations could be fuelled if the public believes we are relying on the wrong tool while neglecting better ones that might get the job done.
But so long as policymakers subscribe to the boilerplate analysis that concludes the hammer is the only tool worthy of consideration, we leave our whole toolbox on the shelf while the Bank of Canada behaves as though the only problem is a nail.