To boldly go

Expectations for the outcome of today's Bank of Canada Governing Council meeting were steadily hardening as the big day loomed. Markets were largely pricing in a 75 basis point rate hike, matching the most recent move by the US Federal Reserve. In the event, the Bank went even further, raising official rates by a full percentage point; the overnight rate target now stands at 2.5 percent. This is the largest single increase in the target since 1998. 

The press release announcing the move is very clear about the reasoning. The final paragraph begins thus: 

With the economy clearly in excess demand, inflation high and broadening, and more businesses and consumers expecting high inflation to persist for longer, the Governing Council decided to front-load the path to higher interest rates by raising the policy rate by 100 basis points today. (Emphasis mine).

The body of the release, which is longer than usual, spells out the logic in more detail. (And there is even more detail to be found in the Monetary Policy Report, also released today). Some highlights:

As regards domestic inflation, the Bank is concerned about both the broadening of current price pressures and the evidence that inflation expectations are rising:

Inflation in Canada is higher and more persistent than the Bank expected in its April Monetary Policy Report (MPR), and will likely remain around 8% in the next few months. While global factors such as the war in Ukraine and ongoing supply disruptions have been the biggest drivers, domestic price pressures from excess demand are becoming more prominent. More than half of the components that make up the CPI are now rising by more than 5%. With this broadening of price pressures, the Bank’s core measures of inflation have moved up to between 3.9% and 5.4%. Also, surveys indicate more consumers and businesses are expecting inflation to be higher for longer, raising the risk that elevated inflation becomes entrenched in price- and wage-setting. If that occurs, the economic cost of restoring price stability will be higher.

As for real activity, the Bank sees strength just about everywhere it looks, resulting in excess demand and tight labour markets:

Further excess demand has built up in the Canadian economy. Labour markets are tight with a record low unemployment rate, widespread labour shortages, and increasing wage pressures. With strong demand, businesses are passing on higher input and labour costs by raising prices. Consumption is robust, led by a rebound in spending on hard-to-distance services. Business investment is solid and exports are being boosted by elevated commodity prices. The Bank estimates that GDP grew by about 4% in the second quarter. Growth is expected to slow to about 2% in the third quarter as consumption growth moderates and housing market activity pulls back following unsustainable strength during the pandemic.

In terms of its economic projections, the Bank expects growth to slow without the economy tipping into recession, but acknowledges that inflation will not return to target for another two years:

The Bank expects Canada’s economy to grow by 3½% in 2022, 1¾% in 2023, and 2½% in 2024. 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. 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.

The release concludes by stating that the Bank will "continue to take action as required to achieve the 2 percent inflation target". That obviously points to more rate hikes ahead, but the Bank is hoping that today's dramatic move will limit the scale of future tightening needed to reach its goal. Given the near-term outlook for CPI to remain sticky above 8 percent, that hope will soon be put to the test.