Dispatches from Ottawa: Bank of Canada’s higher-for-longer world for interest rates deepens political fault lines

The nation’s indebted households and small businesses got some bad news from the Bank of Canada this week — it’s not done with interest rate hikes.

Governor Tiff Macklem raised the overnight policy rate by one quarter of a percentage point to 4.75 per cent on Wednesday, ending his five-month pause and rebooting one of the most aggressive hiking cycles by the central bank ever.

Since the Bank of Canada’s first hike in March last year, short-term interest rates have risen by 4.5 percentage points. Commercial banks have matched every single policy move with a hike of their prime rates — which are now hovering at around seven per cent for most of them.

The central bank this week also effectively put an end to any hopes that borrowing costs would soon fall. In a speech on Thursday,  Bank of Canada deputy governor Paul Beaudry was even more unequivocal about the probability for interest rates to remain elevated for a very long time.

“I am hoping to help Canadians prepare in case it turns out we have indeed entered a new, higher interest rate environment,” Beaudry said.

Markets are now partly pricing in another half percentage point increase by September. The policy pivot toward higher-for-longer interest rates has four important implications.

1. Odds of the soft landing coveted by policy makers are getting more slim. The Bank of Canada was hoping its rate hikes between March and January would be enough to slow down the economy just enough to bring inflation back to target, without causing a major downturn. But Canada’s economy appears to be carrying too much momentum for delicate policy calibration and may require a firmer and blunt stop by the central bank.

2. There may be no scenario where a strong housing market is consistent with stable inflation — at least in the short-term. The central bank was clearly spooked by Canada’s reheating housing markets — seeing it as both a signal of excess demand and growing financial stability risks. Clearly, again in hindsight, the central bank erred when it raised the prospect earlier this year that its hiking cycle was at an end and that lower borrowing costs could be on the horizon — a dovishness that helped reignite home prices. The Bank of Canada is learning from that mistake. 

3. Prime Minister Justin Trudeau’s government will face increasing pressure to support the inflation fight, either through tighter fiscal policy or by slowing international migration that is stoking demand. While the government has reined in pandemic stimulus, it continues to run large budget gaps relative to the economy’s capacity to absorb the deficit spending.

But even if the government wasn’t stoking demand, it would still need to be more engaged in the inflation fight. Finance Minister Chrystia Freeland promised to do as much in the Bank of Canada’s 2021 mandate review, where she acknowledged the government had “joint responsibility for achieving the inflation target.”

4. New political fault lines emerging over the past year because of higher interest rates will only deepen. We’re seeing a very large distribution of income from debtors to savers, and from young to old. Groups on the losing end of this shift will be attracted to the prospect of more equitable trade-offs between interest rates and inflation. In other words, there will be a growing political constituency in favour of  the Bank of Canada tolerating higher inflation to ease interest payment burdens of indebted Canadians.

One consequence of this will be to increasingly politicize the Bank of Canada — being a force of redistribution is an inherently uncomfortable position for technocrats. It will be interesting to see where the country’s three large national political parties settle on the issue, particularly the Conservatives who have been trying to make inroads with youth.