E-sight September 7: Bank of Canada hikes 75 basis points and signals more to come

The Bank of Canada delivered yet another dramatically large interest rate hike at today’s policy announcement, raising its benchmark overnight rate by 75 basis points to 3.25% and signalling its continued selling of bonds as part of quantitative tightening. The actions were in line with financial market expectations and move Canadian monetary policy into a restrictive stance that will help curtail inflation but at the expense of economic growth. And, the central bank is not done, as “the Governing Council still judges that the policy interest rate will need to rise further.” Deloitte anticipates another half a percentage point hike at its next policy announcement on October 26. 

The Bank justified today’s action on the basis of being behind the curve on inflation and on the strength of the economy. Although headline inflation dipped in July on lower gasoline prices, core measures of inflation increased into a range of 5-to-5.5% – dramatically above the Bank’s 2% target for inflation. The central bank also feels that the economy continues to operate in a state of excess demand, as illustrated by the 3.3% annualized growth in the second quarter and the evidence of tight labour markets and labour shortages.  

The Bank acknowledges that global demand is likely to weaken in the second half of this year, which will constrain Canadian economic growth. Meanwhile, domestic demand in Canada will be softened by the increase in interest rates. So, the central bank anticipates that the current state of excess demand will diminish in the coming months. 

My personal take is that the Bank’s communique is extremely hawkish. First, it is very short and to the point. Inflation is too high so they are hiking rates aggressively. They could have put more weight on the coming global economic slowdown, or the contribution of supply chain problems on inflation, or the lagged impact of the global rebalancing of monetary policy on world economic activity. I am struck that that the central bank is not signaling that we are getting anywhere close to a pause in the tightening cycle. Prior to today’s announcement, my expectation was that the peak in the overnight rate would be around 3.75%.  But, it now seems unlikely that the Bank will hike a half a percentage point on October 26 and then suddenly shift to the sidelines. So, unless future Bank of Canada speeches send more dovish signals, it now seems more likely that the overnight rate could reach the 4.00% mark before the central bank moves to the sidelines. With monetary policy now in restrictive territory, the Bank of Canada is really applying the brakes to the economy, and if short-term rates do climb to 4.00%, or perhaps higher, the odds of recession increase materially. However, if a recession does occur, the starting point of broad-based labour shortages and pandemic savings does raise the possibility of a mild downturn.