Bank of Canada Interest Rate Doubled to 1.0%, More Hikes and Balance Sheet Reduction to Come

April 13, 2022

Today’s 50-basis point rate hike, although widely expected, was an historic move. Such represents the first hike of that much by a Group of Seven central bank and the Bank of Canada’s largest incremental rise since 2000. Officials had only recently ended its pandemic relief program of bond purchases to support liquidity and now has also ended the subsequent stage of preserving balance sheet size by reinvesting maturing assets acquired in that program. As a result, balance sheet assets will now be depleted at a monthly rate of about C$ 4-5 billion. 40% of the bond portfolio is scheduled to mature within two years, but ultimately the balance sheet should flatten at a larger level than it was prior to the pandemic. According to the statement released today by the Governing Council,

With the economy moving into excess demand and inflation persisting well above target, the Governing Council judges that interest rates will need to rise further. The policy interest rate is the Bank’s primary monetary policy instrument, and quantitative tightening will complement increases in the policy rate. The timing and pace of further increases in the policy rate will be guided by the Bank’s ongoing assessment of the economy and its commitment to achieving the 2% inflation target.

This week’s policy review coincided with publication of a new quarterly Monetary Policy Report, which goes into greater detail about defining global and Canadian economic conditions and prospects and showing how such have been greatly influenced by Russia’s invasion of Ukraine.  The report presents the framework and assumptions under which Bank of Canada policy will be evolving. Highlights include the following:

  • Growth abroad and in Canada has been revised broadly lower, while projected inflation is higher.
  • The nominal neutral short-term interest rate is about 2.5%. That implies at least 150 basis points and probably more of interest rate increase lies ahead.
  • Global GDP is projected to expand just 3.5% this year, 2.5% in 2023 and 3.2% in 2024. GDP in Euroland will exceed that in the United States in each of those years. Japanese growth is also assumed to be greater than U.S. growth next year and almost as fast in 2024.
  • Canadian GDP rose more than expected last quarter and is projected to strengthen even more this quarter to an annualized pace of about 6%.
  • Canada’s output gap (the difference between actual GDP and the non-inflationary level that can be sustained by the supply side is estimated to have been between -0.25% and +0.75% last quarter. At either extreme, Canada is now clearly moving into a state of excess demand. Higher interest rates are thus warranted and “should moderate spending and gradually reduce excess demand in the Canadian economy.”
  • Inflation in Canada this year will be above 5% this year (and average more than 6% in the first half). It will then decline slowly and stay well above the 2% target in 2023.
  • Two other reasons for ramping up the size of incremental interest rate increase and quantitative tightening are tight labor market conditions and the upward movement of short-term price expectations. So far, long-term inflation expectations remain pretty well anchored to the central bank target, but officials are concerned that the change in the short-term view might spill over into the longer-term view if policymakers do no act is a sufficiently credible way now.

Copyright 2022, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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