Canada’s central bank made its expected rate hike, but the market was still shocked. The Bank of Canada (BoC) hiked the policy rate to 3.25 points today, up 0.75 points from the previous level. Interest rates are now at the highest rate since 2008, and expected to keep climbing due to inflation. Consequently, a hard landing, or recession, is now expected and the odds are against it being a mild one.
The Neutral Policy Rate
For any of this to make sense, you need to understand the basics of policy interest rates. The central bank’s primary role is to ensure low and stable inflation. They do this with one big tool — the policy interest rate.
Central banks have an ideal target range of interest, with the BoC using between 1 and 3 points. If inflation is below 1 point, the BoC might lower rates to make credit cheaper. By doing so, they’re encouraging banks to make more loans to drive inflation, and thus prices higher. That’s where the inflation comes from.
If inflation is above 3 points, they’ll hike rates to cool down the incentive to borrow. This will lower the amount of demand, helping to bring prices down. That’s how they cool inflation — by cooling demand.
The neutral policy rate is the level where interest rates have no influence on inflation. It doesn’t drive inflation or slow it, it’s just right for the level of inflation. You’re going to miss these days, we can already tell.
Here’s the important part for today — BoC research shows it takes 18 to 24 months for policy to arrive to market. If the BoC wanted stable inflation, it was supposed to do it more than two years ago to get the ball rolling. Instead of coming down in a graceful landing, we’re slamming the shifters down, then up, then… you get it. Trying to force something is almost always worse than encouraging it, but at this point the BoC is stuck. This is a key point to understand the information below.
Canada To Face A Moderate Recession
The BoC is signaling the economy is way overheated, to the point it can be destabilizing to the public. “Today’s statement makes clear that with the economy operating in excess demand, tight labour markets and still elevated inflation, the BoC will press forward with further rate hikes despite its forecast for the economy to “moderate” in H2,” said Tony Stillo, a director of Oxford Economics that specializes in the Canadian economy.
Stillo is no longer entertaining fantasies of a mild recession, like some banks. “In our view, Canada is now likely to fall into a moderate recession by late 2022,” he adds.
The primary cause, according to the economist, is aggressive monetary policy. By trying to correct inflation in a short period, they need to apply much more pressure than usual. Canada’s highly indebted households amplify the pain in this emergency landing.
He mentions the “deepening housing correction already underway,” compounding the pain further. Add to that, a global slowdown is fast approaching as well, leading to unknown fallout.
Bank of Canada Expected To Hike Further
Stillo sees the BoC hiking even further in October, bringing the policy rate to 3.75% in just a few months. “From there, we expect mounting signs of a recession in Canada, weakening external demand and continued declines in inflation will cause the Bank of Canada to halt rate hikes,” he says.
“We now think that such rapid tightening of monetary policy given Canada’s a highly interest sensitive economy, along with a deteriorating external environment, make a recession the most likely outcome for the economy.”
Waiting too long to act on inflation put the central bank in a tough position. Canada is now witnessing some of the highest inflation ever. A whole generation hasn’t seen anything even close to this.
Had the central bank tackled inflation when it claimed it was transitory, it would be a different story. However, as the BIS pointed out, central banks repeated policy mistakes around the world. This led to synchronization, which leads to larger risk events. Now we’re starting to see why households being highly indebted in a synchronization event is a disaster waiting to happen.