The Bank of Canada raised its benchmark interest rate by a half point and set out a revised economic forecast that suggests the country will struggle to avoid a recession over the next few quarters. Here’s what you need to know:

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Bank of Canada opts for lower half-point hike, but says more to come Back to video

Rates keep rising

Bank of Canada governor Tiff Macklem said he would continue raising interest rates this fall and he kept his promise. Macklem, with input from his deputies on Governing Council, raised the benchmark interest rate to 3.75 per cent – shockingly high, given that policy rates were close to zero at the beginning of the year.

Policymakers have determined that shock and awe are necessary to battle inflation, which continues to spread despite the central bank’s efforts to adjust behaviour and expectations of where prices are headed with a series of outsized interest-rate increases over the summer. The consumer price index increased 6.9 per cent in September from a year earlier, compared with the Bank of Canada’s target of two per cent. That means Macklem probably isn’t finished yet.

“Given elevated inflation and inflation expectations, as well as ongoing demand pressures in the economy, the Governing Council expects that the policy interest rate will need to rise further,” the central bank said in a statement on Oct. 26. “Future rate increases will be influenced by our assessment of how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding.”

Stall speed

The Bank of Canada is raising interest rates this quickly for two reasons. On an abstract level, it wants to dissuade households and companies of any notion that this post-pandemic burst of inflation will persist. Policymakers reckon the aggressive increases will persuade the public that they are serious about getting inflation back to two per cent. If the public believes them, the bet is that workers will accept muted pay increases and companies will restrain from matching their prices to current inflation.

More concretely, policymakers also want to squeeze “excess demand” out of the economy and rebalance the goods and services we want with the ability of companies to provide them. The Bank of Canada calculates something called the “output gap,” a rough estimate of how the economy is doing compared with its ability to produce non-inflationary growth. The output gap is currently 0.25 per cent to 1.25 per cent, suggesting demand is putting upward pressure on prices.

The Bank of Canada acknowledges that in its rush to stomp out inflation, it could squeeze the economy too hard, triggering a recession. The central bank’s new quarterly outlook shows gross domestic product increased 1.5 per cent in the third quarter, compared with a previous estimate of two per cent, and predicts growth will slow to an annual rate of 0.5 per cent over the final three months of 2022.

Higher borrowing costs are rippling across the economy, starting with housing, which the Bank of Canada thinks will subtract from growth this year and next. The central bank’s forecasters now see consumption adding 0.6 percentage points to growth next year, compared with a previous estimate — when borrowing costs were much lower — of one per cent. The revised outlook predicts the U.S. economy will stagnate next year, while Europe drops into a recession, which can only weaken demand for Canada’s exports.

In all, the Bank of Canada sees growth of 0.9 per cent in 2023, down from an estimate of 1.8 per cent a quarter ago. Policymakers see growth of 3.3 per cent this year, down from 4.5 per cent in 2021.

“Growth is projected to essentially stall later this year and through the first half of 2023,” the Bank of Canada said in its latest Monetary Policy Report. “Reducing demand growth in the economy allows supply to catch up, bringing inflation down.”

Price pressure

Macklem is willingly courting a recession because inflation pressures remain frustratingly persistent. The revised forecast has year-over-year increases in the consumer price index averaging 7.1 per cent over the fourth quarter, and gradually slowing to 2.8 per cent a year from now. The projection has inflation returning to target at the end of 2024.

Early in the pandemic, the Bank of Canada thought that much of the inflationary pressure was coming from global supply bottlenecks and a shortage to labour related to COVID-19. Policymakers assumed those constraints would ease as things got back to normal. The central bank has stopped waiting for normal to return, which helps explain its emphasis on constraining demand at home. It can no longer count on suppliers to rebalance supply and demand on their own.

“The negative effects of supply chain disruptions on productivity and of labour market mismatch that were previously assumed to be temporary are now assumed to be permanent,” the revised outlook said.

Bottom line

Macklem and his deputies conducted their latest round of policy deliberations under unusually intense pressure. Some on Bay Street and Wall Street were expecting a bigger interest-rate increase, so the decision to go with a half-point lift could hurt the value of the dollar, which in turn would put upward pressure on inflation because imports would become more expensive. Those people will look at an outlook that has inflation above target a year from now and conclude the Bank of Canada isn’t sufficiently committed to crushing price pressures.

At the same time, there is a growing chorus that thinks the Bank of Canada and other central banks already have gone too far by pushing their economies to the brink of recession. Those critics point to the Reserve Bank of Australia, which broke from its peers a few weeks ago by opting to surprise with a smaller interest-rate increase, rather than a shockingly big one. That group will be upset by Macklem’s pledge to keep raising borrowing costs, suggesting the benchmark rate is headed to something above four per cent.

Macklem appears to have hedged, maintaining an emphasis on inflation, while implicitly acknowledging with the smaller-than-expected increase that recession risks are growing. It might be the right move for a central bank whose primary mission is to keep inflation at two per cent. However, the negativity swirling around the Bank of Canada these days almost certainly will continue as few critics will be silenced by this decision.

• Email: kcarmichael@postmedia.com | Twitter: CarmichaelKevin

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