Bank of Canada in full tightening mode

With today's policy steps, the Bank of Canada has moved unequivocally into a tightening phase that is likely to continue for some time.  As expected, the Bank raised its overnight rate target by 50 basis points, to 1.0 percent, and for the first time offered some indication of how high it thinks rates might have to go. It also announced the start of quantitative tightening -- it will no longer reinvest the proceeds of its bond holdings as they mature. This shrinking of the Bank's balance sheet is likely to boost interest rates all along the yield curve, reinforcing the impact of the rising cash rate. 

The Bank also introduced its updated Monetary Policy Report, and held a press conference that allowed Governor Tiff Macklem to spell out the Bank's reasoning.  Despite the uncertainty created by the Russian invasion of Ukraine, the tone was unmistakably hawkish. For example:

• As regards growth: "A broad set of indicators suggests that our economy is now moving into excess demand. The labour market shows this clearly. Job growth has been strong, the unemployment rate is at a record low, job vacancies are elevated, and wage growth has reached pre-pandemic levels.....momentum in most major spending components points to strong growth in gross domestic product this year.......the Bank forecasts the Canadian economy will grow 4¼% this year, before moderating to 3¼% in 2023 and 2¼% in 2024."
• As regards inflation: "CPI inflation in Canada hit a three-decade high of 5.7% in February, above what we projected in the January MPR. We now expect inflation to average almost 6% in the first half of 2022 and remain well above our 1% to 3% control range throughout this year. We then expect it to ease to about 2½% in the second half of 2023 before returning to the 2% target in 2024. With inflation broadening and remaining higher for longer, the risk is that Canadians start to think that high inflation will become entrenched."
• As regards interest rates: "The economy can handle higher interest rates, and they are needed.....We also need higher interest rates to keep Canadians’ expectations of inflation anchored on the target, so that as global inflationary pressures from higher oil prices and clogged supply chains abate, inflation in Canada falls back toward the target. We are committed to using our policy interest rate to return inflation to target and will do so forcefully if needed."

Governor Macklem spent some time setting out the Bank's view on what might constitute a neutral (i.e. neither expansionary nor contractionary) rate target: "The neutral interest rate isn’t something we can measure directly. We have to estimate it. And our estimate is between 2% and 3%." 

Most market predictions for the cash rate see it somewhere in this range by the end of this year, but Governor Macklem wasn't quite finished. He added that "we may need to take rates modestly above neutral for a period to bring demand and supply back into balance and inflation back to target."

All in all, this marks a full 180-degree turn from the message we have been hearing from the Bank for several years, that it would keep rates below neutral for as long as needed in order to push CPI back up to the target level. The Bank, like its counterpart in Washington, has been slow to admit just how much and how quickly the inflation outlook has changed. Today's actions leave no doubt that they have finally got the message.