Bank of Canada puts credibility at stake with rate hike pause
Theo Argitis: Dispatches from Ottawa
The nation’s indebted households and small businesses got some good news from the Bank of Canada this week – it may be done with interest rate hikes.
Bank of Canada Governor Tiff Macklem raised the overnight policy rate by one quarter of a percentage point to 4.5 per cent on Wednesday, but announced an indefinite pause to his year-long hiking cycle in order to gauge the impact of higher borrowing costs on the economy.
Since Macklem’s first hike in March last year, short-term interest rates have risen by 4.25 percentage points – one of the most aggressive hiking cycles ever by the Bank of Canada. Commercial banks have matched every single policy rate increase with a hike of their prime rates – which are now hovering at around 6.7 per cent for most of them.
Much has been written about the announcement, but there are some important takeaways and risks worth highlighting.
First, while Macklem warned he is prepared to continue hiking if needed, he’s actually signaling a rate cut is the likely next move.
With elevated rates, the Bank of Canada expects the economy will slow enough by the second half of this year to eliminate much of the excess demand currently fueling prices. Inflation, for example, is seen returning to three per cent by the middle of 2023 and back at two per cent by next year.
The only rate path consistent with the Bank of Canada’s economic outlook is one where borrowing costs will be cut relatively soonish. Investors get this, which is why money markets are pricing in cuts starting later this year. See Andrew Spence’s analysis for a closer look at this idea.
Second, the prospect of lower rates on the horizon will be a strong signal for households and businesses to borrow, especially for those who have been waiting on the sidelines for the hiking cycle to end. That will provide a bit of tailwind to help mitigate some of the economic slowdown that’s coming. But they could also fuel risks to the financial system, particularly if the expected drop in rates stokes demand for variable rate loans.
Which is why we should hope the bank’s forecast is correct. It can’t afford another hit to its credibility. Macklem’s failure to predict last year’s inflation surge came at a huge cost to Canadians. Many borrowed thinking rates would remain low and are now stuck with expensive debt, while unions negotiated wages that turned out to be huge bargains for employers. Should inflation not come down as predicted, Canadians will find themselves paying the price again – eroding further whatever confidence is left in the central bank’s ability to get a handle on the economy.
Bank of Canada losses
At his press conference on Wednesday, Macklem also announced that Finance Minister Chrystia Freeland would be amending the Bank of Canada Act to address losses the central bank is accumulating – an ironic side effect of the hiking cycle.
Early in the pandemic, the central bank bought hundreds of billions worth of federal government bonds from banks and others – a practice known as quantitative easing. To pay for the bonds, the central bank created interest-rate bearing deposits for the sellers.
Now that interest rates are rising, the payments on those deposits are rising too – generating losses for the Bank of Canada that will need to be accounted for by the federal government. Apparently, according to Macklem, Freeland has agreed to allow the Bank of Canada to effectively account for these losses at a future time when there are profits.
An amendment would, presumably, require parliamentary approval, bringing the Bank of Canada to the floor of parliament for the first time in decades. Should be fun.
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