Canada’s economy continues to outperform, despite rising interest rates. In response, the Bank of Canada (BoC) hiked its overnight rate by 0.25 points to 4.75%—the highest rate in over 10 years. To further throttle excess demand, the central bank is also reducing credit liquidity, as it attempts to prevent already elevated inflation from returning to higher growth.
Canadian Inflation Is Decelerating, But Still Way Too High
The global economy is slowing, but Canada is still running hot according to the BoC. Annual growth of the consumer price index (CPI) hit a generational high of 8.1% back in June 2022, and has since fallen to 4.4% in the latest report. It’s progress, but still 120% higher than the central bank’s target, and nearly 50% above its acceptable tolerance level.
The BoC noted that demand was “… more persistent than anticipated,” and the economy is still overheated. Amongst the surprising data points to the upside were: The first quarter reported 3.1% annual growth for GDP; consumption is rising; spending on interest sensitive goods is strengthening; and housing activity has increased.
Most of those factors also get a big boost from the aggressive population growth. Higher rates aren’t just needed to cool overheated demand, but to offset the impact of stimulated demand from population growth.
What Pause? Canada’s Economy Is Still Showing Excess Demand
What happened to that conditional pause? The expectation was that rates wouldn’t climb until at least the latter half of this year, since the central bank flat out said we paused hikes. That pause sent people back into consumption mode, with demand bouncing back almost immediately after the announcement.
Higher rates are designed to throttle demand, and reduce pressure on the supply of goods and services. If hikes come too slowly, the market risks absorbing increased financing costs, and there’s little to no impact on demand. That’s what Canada observed right after the pause—demand fired up almost immediately.
Borrowing Costs Could Rise Even Further Than Just A Rate Hike
An equally large, but under discussed, measure to cool demand is quantitative tightening. The BoC stated the current monetary policy measures are “… not sufficiently restrictive to bring supply and demand back into balance.”
To complement rate hikes, the central bank has been engaging in quantitative tightening (QT). To overly simplify the issue, it’s the opposite of quantitative easing (QE). QE is the expansion of the central bank’s balance sheet to increase credit liquidity, boost demand, and create inflation. QT is the shrinking of the balance sheet to remove liquidity, restrict demand, and cool inflation.
After the US liquidity crisis, we saw an unexpectedly long pause on balance sheet reduction. No shrinking occurred for nearly two months starting in March 2023. In April, the balance sheet shrunk 4.4% over the span of a week—the largest reduction since April 2021, after the state’s pandemic binge tapered down. That’s a big reduction in liquidity, playing a role in rising bond yields, and more expensive fixed rate mortgages.
Rate hikes might be coming as a surprise to households that heard the governor say “pause.” Data-dependent changes to monetary policy never require an apology, but the governor should stop trying to address households directly.
More sophisticated investors know a promise to hold rates doesn’t make sense in a free market, but an average household doesn’t. They’re making decisions when the Governor tells them rates will be low for long, or there’s going to be a pause. Controlling inflation is the central bank’s mandate. Turning every household into a data-dependent trader isn’t.