- BoC goes big again with a 75 basis point hike in September
- 3.25% overnight rate puts monetary policy in "restrictive" territory
- Statement flags further tightening to come, but pace likely to slow
Staying aggressive against inflation, the Bank of Canada (BoC) delivered a 75 basis point hike to increase the target overnight interest rate to 3.25%. The move was largely priced in the markets, and consistent with our base case scenario.
The bank's policy statement was short and sweet, leaving no room for misinterpretation. It carried a very clear message: inflation remains the bogey man and the policy cycle is not over.
It is hawkish, with no pivot, and no two-way risks. The key question it raises is how much higher the policy rate will need to go.
"As the effects of tighter monetary policy work through the economy, we will be assessing how much higher interest rates need to go to return inflation to target," the BoC said in a statement issued on Wednesday. While affirming there are still more hikes to come, this language seems designed to condition the market to a slower pace than 75 basis point increments.
"Given the outlook for inflation, the Governing Council still judges that the policy interest rate will need to rise further," said the Bank. However, it also says it continues to expect the economy to moderate in the second half of this year, as global demand weakens and tighter monetary policy here in Canada begins to bring demand more in line with supply.
Quantitative tightening will also continue, where maturing Government of Canada bonds held by the BoC will not be replaced.
Is the BoC engineering a steady step-down path?
The policy rate (3.25%) is now in slightly restrictive territory (based on the BoC’s stated 2-3% neutral range) and the guidance in the policy statement indicates that it needs to become more restrictive in the near term.
A plausible alternate scenario to the tightening cycle ending in October is that the BoC is engineering a steady, step-down path: 50 basis points in October followed by an open-ended, residual 25 basis points in December, dependent on how quickly excess demand is eroded or core inflation shows signs of moderating.
Price drops at the pump not enough to curb core inflation
A drop in gasoline prices eased CPI inflation in July to 7.6% from 8.1%. But take gas prices out of the picture, and data still indicate price inflationary pressures, particularly in services. In its statement, the Bank cited rising core measures of inflation, ranging from 5% to 5.5% in July, and suggests short-term inflation expectations remain high. "The longer this continues, the greater the risk that elevated inflation becomes entrenched," according to the Bank.
While the global and Canadian economies are in line with the Bank’s July projection, it cites the same causes that continue to hamper growth and boost prices, including the effects of COVID-19 outbreaks, ongoing supply disruptions, and the war in Ukraine.
Canada is no outlier, as central banks around the world take steps to tighten their monetary policy. Measures of core inflation are moving up in most countries. In the U.S., the labour market remains tight. In China, COVID-19 shut-downs continue to challenge manufacturing. Prices for commodities remain volatile, although oil, wheat and lumber prices have moderated.
Wednesday's statement did not cite inflation expectations. The Bank's next inflation forecast is scheduled to be released in its next Monetary Policy Report on Oct. 26. Previously, in July, it said that it expects inflation to ease to about 3% by the end of 2023 and to return to the 2% target by the end of 2024.
Economy still heated by high demand, labour shortages
Canada's GDP growth of 3.3% in the second quarter was somewhat weaker than the Bank had projected, yet the economy remains heated by excess demand, labour shortages and inflationary pressures as businesses pass along higher costs to consumers.
"Indicators of domestic demand were very strong – consumption grew by about 9.5% and business investment up by close to 12% in the second quarter," highlighted the Bank.
The Bank's effort to level off excess demand is cooling one key sector driving inflation: "With higher mortgage rates, the housing market is pulling back as anticipated, following unsustainable growth during the pandemic," according to the Bank.
In a speech Thursday in Calgary, BoC senior deputy governor Carolyn Rogers discusses this week’s decision, in a progress report on the economy.
BoC rate move is in line with expectations
Markets largely held their course following the much-anticipated BoC announcement. The S&P/TSX composite index closed up 0.8% from the previous day, led by financials, industrials and materials, and with a 3.1% decline in energy stocks.
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 October 26, 2022.
We're quickly coming out of an extended period of all-time low interest rates, throughout years of emergency measures. As rates change, it's important to keep a measured view of what's behind the increases, as well as the effects of inflation. Besides higher borrowing costs, rising rates may have an impact on investments and your portfolio. 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), or an MD Private Investment Counsel Portfolio Manager.
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.