With inflation set in its sights, the Bank of Canada raises interest rates to 2.5%

Key takeaways

• The range for the federal funds rate was increased by 0.75% to 1.50-to-1.75%.
• The Fed will continue to reduce the size of its balance sheet.
• The Fed is hawkish: Further rate hikes are coming.

To accelerate the withdrawal of stimulus in its efforts to combat inflation, the Bank of Canada (BoC) raised its target for the overnight rate by 1% to 2.5%. Increasing the interest rate comes as no surprise but most were expecting a 0.75% hike. According to the BoC, the larger than expected jump is to “front-load the path to higher interest rates.” Going forward, we continue to expect additional rate hikes through the end of year; however, we do not believe the overnight rate will exceed the upper bound for the nominal neutral rate (3%) for a prolonged period of time.

Quantitative tightening will also continue, where maturing Government of Canada bonds held by the BoC will not be replaced.

Inflation, inflation, inflation

In its statement issued on Wednesday morning, the Bank now expects inflation to remain around 8% in the near term. It also admitted that inflation is higher and more persistent than what it had been anticipating. Global factors like the invasion of Ukraine and the ongoing pandemic-related supply disruptions remain the largest drivers. The BoC also noted that the impact from excess demand is becoming more prominent, pushing domestic prices higher.

The story is similar on a global level – many central banks are also scaling back supportive policy to combat elevated inflation resulting in tighter financial conditions and slower economic growth. In its latest projections, the BoC now expects global economic growth of approximately 3.5% for 2022, 2% in 2023, before bouncing back to 3% in 2024.

Noted by the Bank, “the July outlook has inflation starting to come back down later this year, easing to about 3% by the end of next year and returning to the 2% target by the end of 2024.

Too much domestic demand

Consumption remains strong, unemployment is at record lows, labour shortages are widespread, upward pressure on wages is increasing, business investment is solid and exports are being bolstered by high commodity prices. These factors are adding to short-term inflationary pressures on prices as businesses pass higher input and labour costs to consumers.

From the Bank’s statement, “Economic activity will slow as global growth moderates and tighter monetary policy works its way through the economy. This, combined with the resolution of supply disruptions, will bring demand and supply back into balance and alleviate inflationary pressures. Global energy prices are also projected to decline.” In its updated Monetary Policy Report, the BoC now expects growth in Canada to slow from 3.5% in 2022 to 1.75% in 2023 and 2.5% in 2024.

Overall direction is in line with expectations

Global equities traded lower on Wednesday (July 13, 2022) morning, likely on the news of U.S. inflation being 9.1% year-over year in June, which was higher than expected (8.8%). Following the BoC’s surprise 1% hike, Canadian equities initially dropped further but returned to pre-announcement levels before noon. Canadian bond yields started the day higher, spiked and returned to pre-announcement levels as well.

We remain underweight equities in our portfolios. Our view is supported by tighter financial conditions and monetary policy. Risks associated with the pandemic, the conflict in Ukraine and the increased probability of a recession persist. We recently increased our allocation to cash as we are slightly underweight Canadian equities and U.S. equities, and underweight international and emerging market equities.

For the fixed income side of the portfolios, we are targeting a flatter yield curve in Europe with the European Central Bank poised to move away from emergency-level rates. We also have a slightly long duration (interest rate sensitivity) bias in North America with expectations that longer-dated yields will come in from current levels as central banks tighten lending conditions amidst slowing economic growth.

The BoC’s next interest rate announcement is scheduled for September 7, 2022.

While interest rates have risen materially in 2022, it’s important to remember that rates are coming off all-time, emergency-level lows. However, if you are wondering how rising rates will impact your finances beyond your investments, here’s what it could mean for you. If you have any questions about this announcement, our positioning or how it will impact you, please contact your MD Advisor*.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.