"The upside risks are of greater concern"

The Bank of Canada kept its rate target unchanged at 0.25 percent today, as expected. However, the tone and wording of the rate announcement itself and of the accompanying Monetary Policy Report (MPR) were somewhat more hawkish than markets had anticipated. A series of rate hikes, likely starting before mid-2022, is now the probable outcome. 

Although the Bank's outlook for domestic growth is slightly lower than before, it is confident that the brief slowdown seen in the early summer is behind us. It describes the current growth picture as "robust", with strong employment gains and patchy labour shortages. It forecasts real GDP growth of 5 percent this year, slowing to around 4 percent in both 2022 and 2023. Growth will be broad based, supported by gains in consumption and investment at home and continuing growth in exports to the US. Based on persistent supply chain challenges, if warns the output gap is likely narrower than it had forecast as recently as July. 

The Bank claims that it had anticipated the recent rise in headline CPI, but admits that "the main forces pushing up prices – higher energy prices and pandemic-related supply bottlenecks – now appear to be stronger and more persistent than expected." It does not now expect inflation to return to the 2 percent target until late 2022, and notes that it will be "closely watching inflation expectations and labour costs to ensure that the temporary forces pushing up prices do not become embedded in ongoing inflation."

If we consider these growth and inflation projections together, it becomes clear that the Bank -- like other central banks around the world -- is operating in uncharted territory here. In more normal times, the rapid GDP growth and shrinking output gap the Bank is expecting would not be compatible with expectations of a decline in inflation. The hope of policymakers is that the unwinding of supply chain problems will both support strong growth and alleviate cost and price pressures, before expectations of persistently higher inflation become entrenched. 

This is by no means a sure thing, and the Bank acknowledges as much in the "Key messages" section of the MPR. While stating that it sees the risks to its base inflation forecast are "roughly balanced", it warns that "with inflation above the top of the Bank’s inflation-control range and expected to stay there for some time, the upside risks are of greater concern."

To clear the decks for the rate hikes that now look inevitable, the Bank has suspended its quantitative easing (QE)  programme and will keep its holdings of Canada bonds roughly constant. It still intends to provide "considerable monetary policy support" to the economy until current slack is absorbed, which  it now expects to happen "sometime in the middle quarters of 2022".  This supports the markets' growing conviction that rate hikes will start as soon as April, with the target rate conceivably reaching the dizzy heights of 1 percent by the end of 2022.