The Bank of Canada has raised its policy interest rate, pushing up borrowing costs for the first time since 2018 and kicking off a series of rate hikes despite heightened economic uncertainty caused by Russia’s invasion of Ukraine.
The central bank’s governing council voted to increase the key overnight interest rate to 0.5 per cent from 0.25 per cent, the first step in a push to bring runaway inflation under control.
This puts the bank on the path to normalizing monetary policy after two years of holding interest rates at record lows to support the Canadian economy through the COVID-19 pandemic.
Bank governor Tiff Macklem and his team proceeded with the rate increase despite disruptions to the global economy resulting from the war in Ukraine and the massive sanctions Western governments levelled against Russia in recent days. These moves included freezing the Russian central bank’s foreign exchange reserves and cutting much of the country’s financial system off from global markets.
“The unprovoked invasion of Ukraine by Russia is a major new source of uncertainty,” the bank said in its rate announcement on Wednesday. “Prices for oil and other commodities have risen sharply. This will add to inflation around the world, and negative impacts on confidence and new supply disruptions could weigh on global growth.”
“Financial market volatility has increased. The situation remains fluid,” the bank added.
U.S. Federal Reserve chair Jerome Powell made similar comments on Wednesday before the House financial services committee, indicating he would back a 0.25-percentage-point rate hike by the Fed later this month, despite uncertainty about the impact of the war in Ukraine.
The Bank of Canada’s decision to start tightening monetary policy comes in response to the highest inflation in decades, which has eroded the purchasing power of the Canadian dollar and challenged the central bank’s credibility as an inflation fighter. It has also become clear in recent months that the Canadian economy has largely rebounded from the pandemic-induced recession and no longer needs emergency monetary policy support.
The rate of inflation hit a three-decade high of 5.1 per cent in January, and consumer price index growth has exceeded the central bank’s target range of 1 per cent to 3 per cent since April of last year.
In January, the Bank of Canada predicted the rate of inflation would remain close to 5 per cent until the middle of the year, then decline to nearly 3 per cent by year-end.
It warned on Wednesday, however, that price increases have become pervasive, and inflation “is now expected to be higher in the near term than projected in January.”
Countries around the world have struggled with high inflation over the past year, as the pandemic disrupted global supply chains and changed consumption patterns, leaving central bankers scrambling to understand what was happening and to adjust their monetary policy levers. The Ukraine conflict adds to both inflationary pressures and economic confusion.
Russia is one of the world’s largest oil and gas producers, and both Russia and Ukraine are major grain exporters. Disruptions resulting from sanctions, countersanctions and the military conflict itself have already pushed up global commodity prices. West Texas Intermediate crude oil hit US$112 a barrel on Wednesday for the first time since 2011.
Higher energy prices tend to benefit the Canadian economy. But they also hit Canadians at the gas pump and feed into production and transportation costs, pushing up consumer prices at a moment when the Bank of Canada is already worried about losing control of the inflation narrative.
“Persistently elevated inflation is increasing the risk that longer-run inflation expectations could drift upwards,” the bank warned. Central bankers pay especially close attention to people’s expectations regarding inflation, as beliefs about the direction of inflation affect where prices actually end up.
“Central banks would normally look through geopolitically driven commodity price pressures, but with inflation already so far above target, the BoC has said it is more concerned about upside risks to inflation than downside,” Josh Nye, senior economist at the Royal Bank of Canada, wrote in a note to clients.
The Wednesday rate hike is the first in what analysts expect will be a quick succession of increases in the coming quarters that could bring borrowing costs back to prepandemic levels next year.
Avery Shenfeld, chief economist at the Canadian Imperial Bank of Commerce, said in a note to clients that the central bank’s outlook for higher inflation means it will likely increase rates more quickly than previously expected.
“Odds are that the bank will deliver the remaining three quarter-point hikes we had allocated for 2022 over the next three rate-setting dates, rather than spread out through the year,” he said.
“We expect it to then pause at a 1.25 per cent overnight rate to take stock of the direction for growth and inflation … before resuming rate hikes in 2023.”
How high interest rates ultimately go in this cycle depends on a range of variables, from the stability of the housing market to how quickly Canadian consumers spend extra savings they accumulated during the pandemic. Financial instruments that track market interest rate expectations point to six more rate hikes over the next year, bringing the policy rate back to its prepandemic level of 1.75 per cent.
Canadian homeowners will likely experience these moves most directly through their mortgages. Variable rate mortgages move in lock-step with the central bank’s policy rate. That means people who have variable rate mortgages will see their monthly payments rise or more of their payments go to servicing interest rather than paying down the principal.
People with fixed-rate mortgages – the majority of homeowners in Canada – could see monthly costs go up when they renew their mortgage agreements.
The rising cost of borrowing could begin to cool Canada’s overheated housing market. Over the past two years, the price of a home in Canada has jumped by 43 per cent, with record-low mortgage rates fuelling demand and allowing home buyers to take out ever-larger loans. The bank noted on Wednesday that activity in the housing market remains elevated, “adding further pressure to house prices.”
The rate decision comes almost exactly two years after the Bank of Canada made the first of several emergency cuts that rapidly brought the policy rate to 0.25 per cent from 1.75 per cent in response to the first wave of COVID-19. The bank also launched an unprecedented intervention into financial markets in March, 2020, pumping hundreds of billions of dollars into the system and quadrupling the size of its balance sheet in a matter of months.
The emergency measures involved buying huge amounts of federal government bonds as part of Canada’s first-ever quantitative easing (QE) program, aimed at holding down interest rates on longer-term bonds and reducing borrowing costs across the economy. It also involved forward guidance: a promise not to raise interest rates until slack in the economy had been absorbed.
The bank slowly wound down these emergency measures over the past two years, ending the QE program in October and dropping its forward guidance in January. Its decision to keep its policy rate near zero, however, looked increasingly inappropriate in light of blistering growth in consumer prices and a rebound in both economic output and employment.
The Canadian economy is performing better than expected, the bank said in its rate announcement. GDP grew 6.7 per cent on an annualized basis in the fourth quarter of 2021, Statistics Canada reported on Tuesday. Preliminary data also show the economy kept growing in January despite health restrictions related to the Omicron variant.
“The rebound from Omicron now appears to be well in train: household spending is proving resilient and should strengthen further with the lifting of public-health restrictions,” the bank said.
Since October, the bank has been in what it calls the “reinvestment phase,” in which it is maintaining the size of its balance sheet, but no longer increasing its holdings of federal government bonds. Policy makers have said they will consider allowing the balance sheet to shrink by letting the bonds mature – a process called quantitative tightening (QT) – after the first rate hike.
“The timing and pace of further increases in the policy rate and the start of QT, will be guided by the bank’s ongoing assessment of the economy and its commitment to achieving the 2 per cent inflation target,” the bank said.
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