Rate shock raises questions over Bank of Canada's rosy view

  7/14/2022 |   SHARE
Posted in Canadian Economy and Interest Rates by Marti Philp| Back to Main Blog Page

Bank of Canada Governor Tiff Macklem’s decision to deliver the biggest interest rate hike in a generation hasn’t sapped his optimism about the nation’s outlook.

Though he surprised markets by cranking up the policy rate by a full percentage point to 2.5%, Macklem tried to fuse his hawkish language around inflation with a soft-landing forecast as the most likely outcome in Canada.

Economists say that will be a challenging feat. It assumes that the tightening cycle will be short-lived with rates barely moving into restrictive territory, and that the combination of high inflation and a weak housing market doesn’t seriously derail consumer spending. The central bank still sees Canada’s economy growing by 1.8% next year and 2.4% in 2024 -- a Goldilocks scenario.

The rosy outlook comes with a big risk. A wrong call on economic growth would be another blow to the central bank’s credibility, which is already in question after repeated missteps in forecasting inflation. 

“Given the extremely aggressive rate hike, that more hikes are coming, and the multi-decade highs in inflation, the path to a soft landing for the Canadian economy may not be achievable,” Benjamin Reitzes, rates strategist with Bank of Montreal, said by email.

Macklem himself said Wednesday that “the path to this soft landing has narrowed” because of elevated inflation.

Though the Bank of Canada expressed confidence in its abilities to hit the runway, missing it is also a real possibility. 

“Recession is technically not the base case, but I do see it close to coin flip. You do have a lot of downside risk when it comes to housing,” said Citigroup economist Veronica Clark, who now sees the central bank hiking the policy rate as high as 4%.

Macklem’s mixed messaging left markets see-sawing, according to Derek Holt, head of capital markets economics at Bank of Nova Scotia. Yields on sovereign two-year bonds jumped as much as 20 basis points before pulling back to about half that. Trading in overnight swaps showed that expectations for the policy rate by the end of the year rose to as much as 3.81%, before settling at 3.69%.

“Markets are struggling with how to interpret the BoC’s forward guidance,” Holt said in a report to investors. “The inflation picture clearly needs restrictive policy in order to meaningfully reassert control and 3% or a little higher offers no such guarantees.”

According to the Bank of Canada’s new forecast, the rate shock it just delivered will keep inflation expectations in check, restraining wage demands and price increases. That’s projected to bring price pressures back down to near 3% by the end of next year -- removing the pressure to raise borrowing costs too far into restrictive territory.  

Macklem said at the news conference the policy rate may only need to rise slightly above 3%, the top end of what the bank considers the neutral range, in order to prevent a wage-price spiral. 

“The Bank of Canada is being very clear in its intention to continue raising rates,” Randall Bartlett, senior director of Canadian economics at Desjardins Securities Inc., said in a report to investors. “This will cause economic activity to come down even more rapidly than we anticipated.”

Source: Bank of Canada Governor Tiff Macklem’s decision to deliver the biggest interest rate hike in a generation hasn’t sapped his optimism about the nation’s outlook.

Though he surprised markets by cranking up the policy rate by a full percentage point to 2.5%, Macklem tried to fuse his hawkish language around inflation with a soft-landing forecast as the most likely outcome in Canada.

Economists say that will be a challenging feat. It assumes that the tightening cycle will be short-lived with rates barely moving into restrictive territory, and that the combination of high inflation and a weak housing market doesn’t seriously derail consumer spending. The central bank still sees Canada’s economy growing by 1.8% next year and 2.4% in 2024 -- a Goldilocks scenario.

The rosy outlook comes with a big risk. A wrong call on economic growth would be another blow to the central bank’s credibility, which is already in question after repeated missteps in forecasting inflation. 

“Given the extremely aggressive rate hike, that more hikes are coming, and the multi-decade highs in inflation, the path to a soft landing for the Canadian economy may not be achievable,” Benjamin Reitzes, rates strategist with Bank of Montreal, said by email.

Macklem himself said Wednesday that “the path to this soft landing has narrowed” because of elevated inflation.

Though the Bank of Canada expressed confidence in its abilities to hit the runway, missing it is also a real possibility. 

“Recession is technically not the base case, but I do see it close to coin flip. You do have a lot of downside risk when it comes to housing,” said Citigroup economist Veronica Clark, who now sees the central bank hiking the policy rate as high as 4%.

Macklem’s mixed messaging left markets see-sawing, according to Derek Holt, head of capital markets economics at Bank of Nova Scotia. Yields on sovereign two-year bonds jumped as much as 20 basis points before pulling back to about half that. Trading in overnight swaps showed that expectations for the policy rate by the end of the year rose to as much as 3.81%, before settling at 3.69%.

“Markets are struggling with how to interpret the BoC’s forward guidance,” Holt said in a report to investors. “The inflation picture clearly needs restrictive policy in order to meaningfully reassert control and 3% or a little higher offers no such guarantees.”

According to the Bank of Canada’s new forecast, the rate shock it just delivered will keep inflation expectations in check, restraining wage demands and price increases. That’s projected to bring price pressures back down to near 3% by the end of next year -- removing the pressure to raise borrowing costs too far into restrictive territory.  

Macklem said at the news conference the policy rate may only need to rise slightly above 3%, the top end of what the bank considers the neutral range, in order to prevent a wage-price spiral. 

“The Bank of Canada is being very clear in its intention to continue raising rates,” Randall Bartlett, senior director of Canadian economics at Desjardins Securities Inc., said in a report to investors. “This will cause economic activity to come down even more rapidly than we anticipated.”

Source: Canadian Mortgage Professional

Bank of Canada, Bank of Canada Benchmark Rate, Interest Rates