One small step

As expected, the Bank of Canada today raised its overnight rate target by 25 basis points to 0.5%, the first rate increase since 2018. It signaled that more rate hikes are coming, despite growing uncertainty over the outlook, but for the time being is holding off on reducing the size of its balance sheet. 

The case for rate hikes was clear by the start of this year and recent economic data have only served to underline it. Economic growth in Q4/2021 was well above the Bank's expectations at 6.7 percent (annualized rate), which "confirms its view that economic slack has been absorbed".  The Bank believes that the impact of the omicron COVID variant is already fading, so that "first-quarter growth is now looking more solid than previously projected".

As for inflation, the January reading of 5.1 percent is of course far above the Bank's target range: "Price increases have become more pervasive, and measures of core inflation have all risen". Monetary policy may have little effect on the current causes of inflation, but the Bank's concern is to ensure that inflation expectations do not drift away from the 2 percent target. Therefore "The Bank will use its monetary policy tools to return inflation to the 2 % target and keep inflation expectations well-anchored". 

Viewed in a vacuum, this language and the recent data would clearly signal the Bank's intention to raise rates several more times during 2022 , and until a week ago this was the consensus expectations among Bank-watchers. The Russian invasion of Ukraine is a huge complicating factor. Gasoline prices at the retail level are set to reach all-time highs by this weekend in response to the soaring cost of crude, and the impact of the war will inevitably spill over into other commodities, as the Bank's press release makes clear.

The growth impact of the events in Ukraine is more complicated from a policy standpoint. The press release notes that "negative impacts on confidence and new supply disruptions could weigh on global growth". In the aggregate this is certainly true, but as Canada is a net energy exporter, the impact is likely to vary widely across the country. The oil patch in Alberta and Saskatchewan was already booming before the Ukraine crisis boosted energy prices yet further, while energy importing Provinces such as Ontario could take a significant hit. This will create a tricky balancing act for the Bank:  2022 shapes up as one of those years where a "one size fits all" monetary policy is way less than ideal. 

The stage is set

Not that there was much doubt anyway, but the strong Canadian GDP data released by Statistics Canada today make it certain that the Bank of Canada will start a tightening cycle on Wednesday, raising its rate target by 25 basis points. It would normally be safe to assume that this would be the first of several moves this year, but the extreme uncertainty over the geopolitical situation makes it hard to be sure how quickly the Bank will be able to act.

Real GDP rose 1.6 percent in the final quarter of 2021, up from 1.3 percent in the prior quarter. This brought growth for the year as a whole to 4.5 percent, following on from the 5.2 percent decline posted in 2020 -- a decline which, it should be recalled, was entirely concentrated in the first half of the year.  In some respects the Q4 data were a little weaker than the headline suggests: final domestic demand rose only 0.7 percent, less than half the rate posted in Q3. Real growth was driven by the rather obscure category of home ownership transfer costs, as well as a rise in business inventories that historical trends suggest is unlikely to persist for very long. 

StatsCan also reported real GDP data for the month of December. This showed GDP basically unchanged from the previous month, which is a surprisingly strong reading given the hasty reimposition of COVID restrictions as the omicron wave ramped up. As these restrictions remained in place through January, it is equally surprising that StatsCan's preliminary estimate for that month sees GDP growth of 0.2 percent. This points to a robust growth pace for Q1 as a whole, given the removal of many of the COVID restrictions in February and early March. 

It remains to be seen whether rate hikes can bring inflation back towards the Bank of Canada's 2 percent target without slowing the economy to an unacceptable degree. Much of the upward pressure on prices is due to supply chain issues, which are hardly unique to Canada. The Russian invasion of Ukraine will only add to international inflationary pressures, in areas from energy to wheat and fertilizers. The Bank's main hope in raising rates at this stage must be to keep inflation expectations in check as it waits and hopes for international pressures to ease. The timing for that seems to be growing more uncertain by the day. 

Another unwanted record

Yet another unwelcome surprise on the inflation front in Canada. Statistics Canada reported today that headline CPI rose 5.1 percent year-on-year in January, up from 4.8 percent in December. That's the fastest pace since September 1991. Lest anybody should miss the point (we're looking at you, Tiff Macklem), StatsCan carefully recorded in the first paragraph of its press release that exactly a year ago, the year-on-year increase in CPI was 1.0 percent.

Excluding gasoline -- which continues to soar in price, rising 4.8 percent in the month of January alone -- the increase was 4.3 percent. That is, of course, still far above the Bank of Canada's 2 percent target.  In any event, with all components of the index rising, there is less and less consolation to be had from leaving out the more volatile components. Ominously, the month-to-month increase in headline CPI for January was a whopping 0.9 percent, and with gas prices at the pump still rising on an almost daily basis, there is little sign of any early reversal in the adverse trend. 

The Bank of Canada's three preferred measures of core inflation all tell the same story as the headline figures.  All three measures rose yet again in January; one of them -- CPI-trim -- has now reached 4.0 percent, and the mean of these measures is now 3.1 percent.

Given these trends, the Bank of Canada's decision not to start raising rates in January is just as incomprehensible as the lack of action from the Federal Reserve.  Both central banks have stated that one of their key aims is to keep inflation expectations well-anchored to the 2 percent target level. The longer inflation is allowed to keep moving further and further above that level, the harder that is likely to be. 

UPDATE, 17 February:  Globe and Mail headline -- "Bank of Canada may need to be 'forceful' in face of high inflation, Deputy Governor says". Too late for that!  

That's convenient!

Ontario's latest fiscal update was released on Valentine's Day, and went almost unnoticed amid everything portentous that's going on in Canada and around the world. That's a pity, because it looks as though the Province's dramatic fiscal improvement will be one of the key planks in the election platform for Doug Ford's Tories come the June election.

The Province's Finance Minister, my old Bay Street oppo Peter Bethlenfalvy, announced that the projected deficit for the 2021-2022 fiscal year (April-March) is now C$ 13.1 billion, $ 8.4 billion lower than the figure projected just three months ago in the mid-year update. The improved outlook is almost entirely the result of a $ 8 billion estimated improvement in Provincial revenues, itself a direct result of a better-than-expected rebound in the Provincial economy.

Bethlenfalvy is required to table a budget by March 31, and will no doubt delay until as close as possible to that date so as to maximize the positive impact on the Tory election campaign. The impact of the omicron COVID variant is not entirely captured by this week's data, but it is hard to imagine that Bethlenfalvy hasn't thought of that, and may indeed have kept some good news in reserve so as to announce an even better fiscal outcome on budget day.

So the main elements of the Tory election platform are falling into place.  Fiscal improvement? Check!  Removal of almost all health restrictions? Check!! Abolition of fees for annual renewal of auto license plates? Check!!! Doug Ford is a charmless boor, but it would be brave to bet against his winning another term, given the lackluster opposition he faces. 

Onwards and upwards, unfortunately

There's not much that need be said about the US January CPI data released this morning by the BLS.  Headline CPI rose 0.6 percent in the month, higher than market expectations, bringing the year on year increase to 7.5 percent, its highest level since February 1982. The energy sub-index rose 27 percent from a year ago; excluding food and energy prices from the calculation gives a core CPI increase of 6.0 percent, the highest since August 1982. 

There is no relief in sight in the short term. Global energy prices continue to rise, against a background of economic recovery and simmering geopolitical tensions. Unless the February month-on-month increase falls below the 0.4 percent seen in February 2021, year-on-year headline CPI will hit a fresh multi-decade high. It is only towards mid-year that this "base effect" might start to exert a moderating influence on the yearly figure, as last year's outsize monthly gains start to fall out of the calculation. 

Not surprisingly, the data have renewed speculation about the pace of Fed tightening, as well as reviving debate over why the Fed did not make its first move at the January FOMC session. There is talk of a 50 basis point initial move in March, as well as suggestions that rate hikes totalling 200 bp might be needed by year-end. The upward pressure on market rates is pushing the 10-year Treasury yield ever closer to 2 percent and moving mortgage rates rapidly higher. 

It is quite possible that the underlying causes of this inflationary spike mean that rate hikes will be relatively powerless to stop it, unless the Fed is willing to bring the economy to a screeching halt. Even if that is the case, the Fed cannot really afford to delay much further: another couple of months of four-decade highs in inflation will severely damage the prospect of keeping inflation expectations under control.  If a 50 bp hike in March sent a strong signal to markets and consumers alike, it might actually reduce the scale of the overall tightening needed to get CPI back to more acceptable levels. There will certainly be voices in the FOMC calling for such a move. 

Wow, that's bad! Wow, that's good!

Employment reports for January in Canada and the United States could scarcely have been more divergent...

Statistics Canada reported that employment fell by 200,000 in the month, far higher than the 100,000 job losses expected by the market. This pushed the unemployment rate up by 0.5 percentage points to 6.5 percent.  The decline ended a run of seven consecutive gains in employment and was the first time the unemployment rate has ticked higher since April 2021, the peak of the long-forgotten delta wave of COVID.  Increases in employee absences and in the number of employees working fewer than their usual number of hours offered further evidence of the weakness in the jobs market during the month. 

The job losses were entirely the result of fresh restrictions imposed by Provinces in response to the emergence of the omicron variant of COVID. This is clearly shown by the sectoral distribution of those  losses. As in previous COVID waves, the worst-hit sectors included accommodation and food services (down 113,000), retail (down 26,000) and culture and recreation (down 48,000).  These losses in the service sectors were only marginally offset by a gain of 23,000 jobs in the good producing sector. 

The good news here is that the fall in employment is expected to be very short-lived indeed. Ontario and Quebec, which shed 146,000 and 63,000 jobs respectively in January, were the first Provinces to feel the effects of omicron and the first to reimpose lockdown measures. Both have already eased some of those measures as omicron begins to wane, and other Provinces are following suit. It is unlikely that all the jobs lost in January will be recovered in February, but if plans to continue easing restrictions move ahead as planned then the positive trend seen since mid-2021 should be fully restored by March.  

Non-farm payrolls data released by the BLS today provide a remarkable contrast, in terms of both the headline number and the composition of the data. Total employment rose by 467,000 in January, far exceeding market expectations for a gain of about 150,000. The BLS reports that strong employment gains were seen in leisure and hospitality (+ 151,000) and retail trade (+ 61,000), precisely the sectors that saw the worst declines in Canada.  The US effectively chose to tough out the omicron wave, imposing few new restrictions; the fact that it is now seeing COVID cases decline in every state except Alabama might suggest that Canada's more draconian approach to the virus was misguided on this occasion. 

Just to add to the impression of a strong US labour market, the BLS also released its annual seasonal adjustment adjustments (so to speak) for 2021. Some of the extraordinary increases initially reported around mid-year have been revised sharply lower, but this is offset by an upward revision totalling almost 700,000 for the November and December figures. This is a technical change rather than a fundamental reassessment, but it does underline how strong the US jobs market is as the end of the pandemic phase of COVID comes faintly into view. 

As for the policy implications, the outlook for the Fed is straightforward: rates will start moving higher in March, leaving only the lingering question of why the tightening did not begin in January. The fall in the stock market as soon as today's numbers were released is evidence that the markets are expecting not just one rate hike but a series of them.

It may be a little trickier for the Bank of Canada, despite its recent rhetoric. Any employment rebound in February will not be reported until after the Bank's March 2 rate setting date, and raising rates in the wake of such a weak employment number will not be a good look. The expected weak December GDP data (due on March 1) would complicate the issue further. A rate hike is still overwhelmingly likely, but the accompanying press release will require some careful drafting.   

Tiff talks tough

A scheduled appearance before the Senate Banking Committee this week afforded Bank of Canada Governor Tiff Macklem an opportunity to restate the Bank's current policy approach (it's going to tighten) and to explain why it did not start the process in January (omicron). A few highlights.....

Macklem stated that he Bank's current message is threefold:

"First, the emergency monetary measures needed to support the economy through the pandemic are no longer required and they have ended.

Second, interest rates will need to increase to control inflation. Canadians should expect a rising path for interest rates.

Third, while reopening our economy after repeated waves of the COVID-19 pandemic is complicated, Canadians can be confident that the Bank of Canada will control inflation. We are committed to bringing inflation back to target."

The key element here from a policy standpoint is the commitment to get inflation back to the 2 percent target. As in the US, all talk of inflationary pressures being "transitory" has been squelched. Macklem now expects headline CPI to remain near 5 percent through mid-year, slow to about 3 percent by year end and then finally move back "close to" the target in 2023 or 2024. As the Bank made clear in its policy statement in January, achieving even this relatively slow decline in headline CPI will require rate increases. However, it continues to believe that longer-term inflation expectations remain well-anchored to the 2 percent target, though it may be said that even a cursory reading of newspaper headlines would tell a different story on that score.  

If bringing inflation back to target is now the key goal, why did the Bank not start the process with a rate hike in January?  The answer comes down to the impact of the omicron variant, which persuaded the Bank to hold off on an immediate move while signalling strongly that rate hikes were imminent:

"Our approach to monetary policy throughout the pandemic has been deliberate, and we were mindful that Omicron will dampen spending in the first quarter. So we decided to keep our policy rate unchanged last week, remove our commitment to hold it at its floor, and signal that rates can be expected to increase going forward."

An early indication of the impact of omicron will be released on Friday (February 4) in the shape of the January employment data. Market expectations are for the loss of as many as 100,000 jobs in the month, ending a run of several months of solid gains. However, it is very likely that the setback will be  short in duration, as Provinces right across the country have already begun to lift the restrictions that were hastily put in place when omicron arrived. A 25 bp rate hike in March seems certain, with at least three more to follow as the year unfolds.