Why did the BoC decide against raising rates in January?
The BoC left interest rates unchanged at 0.25% at its meeting on January 26. The central bank’s decision defied market expectations and caught many investors off guard.
While the Bank of Canada (BoC) chose to leave interest rates unchanged, the communication from the bank’s Governor Tiff Macklem was far from dovish. All signs point to a central bank intent on hiking rates soon, probably in March, and many times after—at least, that appears to be their current intention.
Key quotes from Governor Macklem’s video press conference that seemed aimed at communicating multiple hikes ahead include:
“Everybody should expect interest rates to be on a rising path.”
“We've been very clear that we are announcing a significant shift in policy and to expect a rising rate path and the time for emergency policy is gone.”
“When we say 'a path,' it does not mean one move, it means a number of steps.”
The BoC also updated its range of forecasts, which are supportive of more interest-rate hikes ahead. Importantly, GDP was revised higher, from 3.7% to 4.0% for 2022 and from 3.3% to 3.5% for 2023. Inflation was also revised upward, to 4.2% for 2022 and 2.3% for 2023. Both of these revisions are consistent with hikes ahead.
Latest economic forecast from the BoC
So why not hike rates?
While there’s no shortage of commentary suggesting that the BoC lost its nerve at the eleventh hour, we think there are valid reasons why the bank decided against pulling the trigger this time.
The technical reason for holding fire is that the bank had been consistently noting in its policy statements (since early on in the crisis) that it was “committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.” Indeed, the central bank didn’t indicate at the time that economic slack had already been fully absorbed.
This sentence has since been removed from the January statement, and in its place, the following was added: “a broad set of measures are now indicating that economic slack is absorbed.” Had the BoC hiked rates in January, it would have undermined the credibility of its forward guidance tool, a key component of its monetary policy tool kit. In our view, delaying the rate hike by five weeks should have no particular bearing on the Canadian economy or inflation, but it does keep the central bank’s credibility intact.
"While there’s no shortage of commentary suggesting that the BoC lost its nerve at the eleventh hour, we think there are valid reasons why the bank decided against pulling the trigger this time."
A more subjective (but also plausible) view would be that the Omicron variant and associated public health measures shut down a significant segment of the Canadian economy in January, which heightened uncertainty. While it appears that the central bank has judged that the variant will have only a temporary effect on growth, we won’t really know until economic data is available. We should have a much better perspective on Q1 growth and whether Omicron is indeed just a one-off factor by the March meeting.
How many rate hikes, and when?
The market is now pricing in between five and six hikes from the BoC in 2022.¹ In practical terms, that would mean hiking at every BoC meeting except one, plausibly in the summer, during which further balance sheet tightening would be announced. Markets are expecting the bank to be more aggressive than the U.S. Federal Reserve (four to five hikes), where inflation is actually higher relative to Canada.
"The global macro backdrop should also make it more difficult to raise rates despite the desire to normalize policy."
Our current thinking—which is some distance from the consensus view—is that the BoC can only manage to hike twice this year because growth and inflation are likely to slow materially in the coming months. The global macro backdrop should also make it more difficult to raise rates despite the desire to normalize policy. The risk to our view is that the BoC remains steadfast and chooses to normalize policy regardless, focusing implicitly on dampening the housing sector and withdrawing extraordinary levels of support now that the economy is no longer in crisis. If so, then more rate hikes are indeed possible (but as a result, that would necessitate a lower growth profile and a downgrade in our own forecasts for GDP).
Crucially, we believe the market has been priced to perfection—at this point, it’s difficult to see how the markets will price in even more rate hikes. As such, we believe the risks to market pricing are on the downside.
Our core BoC views
We maintain that the BoC has limited influence on the current levels of inflation, with the exception of housing; yet housing isn’t the primary driver behind the elevated inflation levels in Canada. Monetary policy has virtually no influence on supply factors, be it ports, truckers, weather, global trade policies, or COVID-zero policies. While higher rates can dampen demand, it’s worth noting that even the demand element of demand-supply mismatches that are pushing prices higher are global in nature. When Governor Macklem said that the BoC “can and will” control the cost of living, we believe that he’s mistaken: Monetary policy can’t—and won’t—be the reason inflation will ease later this year.
We also struggle to understand how some commentators can expect the bank to raise rates by five or six times this year without expecting a commensurate decline in growth. The Canadian economy is very sensitive to interest-rate movements, probably now more than in recent years, given its record reliance on the housing sector. In our view, the Canadian economy simply cannot comfortably absorb five to six rate hikes this year and a couple more in 2023. This is also what the bond market is telling us: The Canadian yield curve is continuing to flatten aggressively.
1 Bloomberg, as of January 28, 2022.
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