BoC: The Fire Next Time
The Bank of Canada chose to hold its key overnight lending rate at 0.25%, where it has held fast since March/20. Markets were heavily leaning to a hike today, although it was seen as almost a coin toss by analysts, and we had been holding to a "no change just yet" call. Even with today's mildly surprising decision (to the markets), our view remains that the Bank will begin moving with some haste in the months ahead. In each of the past four tightening cycles, the Bank has started with back-to-back hikes, and we expect a move in early March (just five weeks from today), to be followed by hikes in April and June. After the initial flurry, we look for one hike at each of the quarterly MPR meetings which would be a reasonably fast response, and bring rates back to their pre-pandemic levels (of 1.75%) by next April. While the precise timing of Bank moves is obviously not preset (as evidenced by today's mild surprise), the point is that rates are primed to move steadily higher in the year ahead, and the risks are skewed that the Bank will move faster over the next year.
Reinforcing that point, the Bank sent as loud a warning shot that rates are going up at the next meeting as they possibly could (without an explicit pledge). Governor Macklem strengthened the warning in his remarks in the press conference, and again committed to bringing inflation back to target and said Canadians should expect higher rates in a "series of steps". In the Statement, they removed forward guidance, told us that slack was essentially gone, and that they are concerned that current high inflation rates may get embedded into expectations—it doesn't get much clearer than that. In the Bank's words: "Looking ahead, the Governing Council expects interest rates will need to increase, with the timing and pace of those increases guided by the Bank’s commitment to achieving the 2% inflation target."
The Bank's latest economic projections help explain the clarity of the need for rate hikes. As the attached table shows, the Bank has further lifted its inflationprojections for 2022, from what had been a bit above consensus at the last MPR. For example, they now see inflation averaging 4.2% this year (up from 3.4% just three months ago, and even above our latest call of 3.8%). Note especially their call for the 12-month rate at the end of this year, where they have lifted the forecast almost a full point to 3.0% y/y from 2.1%. And, they are anticipating inflation will peak above 5% in the current quarter, even with the mild assumption that WTI will average $75. Looking out into 2023, they are holding the line with their call of an average rate of 2.3%, but that's still above their 2% target rate. The Bank continues to assert that long-term inflation expectations are well anchored, but they are flashing some concern on that front.
On the growthfront, the Bank has raised its estimate for Q4 growth to nearly 6%, but—like us—has carved its expectation for Q1 to 2.0% (we're even lower at flat). For all of this year, the GDP outlook has been chopped from 4.3% to 4.0%, while next year has been shaved to 3.5%—curiously, both precisely in line with our latest forecasts (so, clearly no quibbles here!). Even with this growth downgrade, the Bank believes this has had little effect on the output gap, as Omicron has also hit the supply side heavily. Indeed, the Bank estimates that various supply chain issues will temporarily hold overall supply down by roughly 2% at the peak impact in 2022Q4. Besides the inflation backdrop, the Bank also signaled some increased concern around the raging housing market, yet that concern clearly was not enough to tip the balance.
The Bank chose to make no changes on their asset purchases yet, and are still reinvesting to keep the balance sheet roughly stable. However, the Bank hinted heavily that this could change as soon as they begin raising interest rates. Policy could quickly morph to QT as early as the spring, reinforcing the tightening from short-term rate hikes.
Bottom Line: We don't believe that today's decision to hold steady at all deflects from the fact that rates are going higher in a relatively forceful fashion this year. This specific decision was likely driven by the fact that a) the economy is dealing with a serious short-term hit from Omicron-driven restrictions, and b) the Bank had consistently guided to rate hikes a bit later on, and did not want to so abruptly run against their guidance. We believe this was a prudent decision, even as we see the need for higher rates (and with pace) as much as any forecaster. Assuming restrictions begin to lighten in the weeks ahead, prepare for rate hikes just five weeks from today.