OTTAWA—The Bank of Canada upped its trendsetting interest rate by 100 basis points—a full percentage point—to 2.5 percent on July 13 in its ongoing battle to lower runaway consumer price inflation. The increase marks the biggest one-time increase in the rate since 1998.
“The Governing Council decided to front-load the path to higher interest rates,” according to the BoC’s press release.
Financial markets were widely expecting an increase of ¾ of a percentage point after the U.S. Federal Reserve raised its fed funds target range by that amount on June 15.
The central bank said that inflation is “higher and more persistent” than it projected in April when it last issued quarterly forecasts and that inflation will “likely remain around 8 percent in the next few months.”
Inflation hit a 39-year high of 7.7 percent in May and has been above the central bank’s 3 percent upper limit of annual inflation’s target range since April 2021.
Notably, the central bank is showing greater concern about rising inflation expectations based on its surveys of businesses and consumers, which indicated that those groups are expecting inflation to remain higher for longer.
In its monetary policy report (MPR), the central bank said that those survey results suggest greater uncertainty over the future path of inflation, which raises the risk of inflation expectations becoming de-anchored and moving further away from the 2 percent inflation target. The MPR illustrated how the distribution of inflation expectations has widened and shifted higher as compared with the situation in April.
Most of the surge in inflation is being driven by global factors such as high energy and food prices, according to the BoC. But it also said “domestic price pressures from excess demand are becoming more prominent.”
The bank noted that over half the components that make up the consumer price index from which the rate of inflation is calculated are rising by over 5 percent.
The bank is expecting inflation to ease to about 3 percent by the end of 2023 before returning to the 2 percent target by the end of 2024.
The BoC has had a poor track record of forecasting inflation and provided an appendix in the MPR elaborating on the main factors behind inflation forecast errors. The largest source of underestimating inflation was the rise in oil prices as the BoC assumes flat oil prices over its projection horizon. The bank explained that as the Canadian dollar has been acting as less of a “petro-currency,” it has not appreciated in tandem with oil prices and has thus not provided as much of an offset to inflation.
Soft Landing
The bank is not expecting the Canadian economy to fall into a recession even as it expects further rate hikes over its projection horizon. The so-called “soft landing” of avoiding a recession is the bank’s base case projection for the Canadian economy.
The Bank of Canada projects the Canadian economy will grow 3.5 percent in 2022 before slowing to grow 1.75 percent in 2023. The growth projection for 2024 picks up to 2.5 percent when housing stabilizes and is no longer a drag on economic growth.
The bank also commented on labour shortages, which are pushing up wage growth. It noted that businesses are raising prices due to higher input costs and wages.
The labour market is becoming even tighter as unemployment rate dropped to a new record low of 4.9 percent in June and wages surged 5.2 percent year-over-year compared to May’s 3.9 percent increase.
“The labour market is tight along all dimensions,” according to the MPR.
The 1 percent rate hike matches the biggest single rate hike the BoC has ever done under its current framework with a target for the overnight rate. The central bank also raised rates by a full percentage point in August 1998 to support the value of the Canadian dollar. The July 13 rate hike comes after two consecutive 50-basis-point increases.
