Canada May Need Tighter Monetary Policy If The Economy Remains Overheated: Bank of Canada

Canada’s economy is just too darn strong, and it’s become a thorn in the central bank’s paw. That was the takeaway from Bank of Canada (BoC) Governor Tiff Macklem’s speech to the Standing Committee on Finance to discuss inflation this morning. Inflation is easing but remains more than three times its target. If meaningful progress doesn’t appear soon, the Governor warns that further monetary policy tightening will be needed. 

Inflation Targets, Supply, and Demand

First, a little background for those just learning about monetary policy, and its role in driving inflation.  

Central banks adopt an inflation target to ensure a stable currency. The target needs to be low enough that it isn’t restrictive, but high enough to prevent the hoarding of cash. The current BoC inflation target is 2%, and its primary tool for achieving it is influencing demand via interest rates. 

Many factors can cause inflation, but monetary policy is the key driver in the current environment, and the BOC is treating it that way. When inflation is too low, central banks “ease” by reducing interest rates and essentially flood the market with cheap money. This allows people to borrow their future income for consumption today. The goal is to intentionally overrun the current supply to create higher prices, aka inflation. 

When inflation is too high, a problem many central bankers thought impossible in this era, monetary tightening is needed. The most common way to tighten is by raising interest rates—reducing leverage, and making borrowing less attractive. This leads to softer demand, reducing pressure on supply and easing price growth.  

BoC research previously found that it takes 18 to 24 months for monetary policy to work its way through the system. That means we haven’t even seen the full impact of the first rate hike this cycle, which occurred in March 2022. 

Now, onto today’s speech. 

Canada’s Economy Is Still Overheated, Even With Soaring Rates 

Despite all of the recession talk, Canada is showing few indicators of a slowing economy. The Governor highlighted robust employment data, showing near record-low unemployment, lofty job vacancies, and companies still reporting labor shortages. On paper, this isn’t a slowdown—it might be one of the best economies ever, even if it doesn’t feel that way with the soaring cost of living. 

 “The Canadian economy remains overheated and clearly in excess demand, and this continues to put upward pressure on many domestic prices,” the Governor bluntly explained. 

No, it’s not just your Realtor—there are also signs of the economy slowing. The Governor used examples of interest rate-sensitive industries, like housing and furniture, to show higher rates have already begun to work. 

They also point to slowing consumption growth, though that was expected anyway. Multiple reopenings of the economy aren’t a thing, right? 

“Overall, the restrictive stance of monetary policy is helping to rebalance demand and supply,” explained the Governor. 

He reiterated the central bank’s January forecast, showing next to zero gross domestic product (GDP) growth for the first 3 quarters of 2023. Ideally, the central bank sees inflation returning to its 2% target by 2024. 

Canada Might Require Further Monetary Policy Tightening

It won’t be easy to cut the current rate of inflation by two-thirds, to get back to target. For that to happen, all of the positive employment data above would need to be unwound. 

“For inflation to get back to 2%, the effects of higher interest rates need to work through the economy and restrain spending enough for supply to catch up,” explained the Governor. 

Adding, “The tightness in the labor market needs to ease, wage growth needs to moderate, and service price inflation needs to cool. Inflation expectations also need to come down and businesses return to more normal pricing behavior.” 

Without an erosion in labor and consumer purchases, Canadians might face even higher interest rates. “If those things don’t happen, inflation will get stuck above our 2% target, and additional monetary tightening will be required,” warned the Governor. 

That might be a problem, the market has begun to price in interest rate cuts. Risks are stacking to the upside.