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Bank of Canada moves up rate hike forecast, ends QE amid higher inflation

Financial Post logo Financial Post 2021-10-27 Kevin Carmichael
Tiff Macklem, governor of the Bank of Canada, listens during a news conference in Ottawa. © Provided by Financial Post Tiff Macklem, governor of the Bank of Canada, listens during a news conference in Ottawa.
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The Bank of Canada ended its bond-purchase program and altered its timeline for when businesses and households should expect higher interest rates, as its revised forecasts predict inflation will flirt with a rate of five per cent for the rest of the year.

“The main forces pushing up prices — higher energy prices and pandemic-related supply bottlenecks — now appear to be stronger and more persistent than expected,” governor Tiff Macklem and his deputies said in a statement at the end of their latest round of policy deliberations on Oct. 27.

“The bank is closely watching inflation expectations and labour costs to ensure that the temporary forces pushing up prices do not become embedded in ongoing inflation.”

Policy-makers said they would stop creating money to buy Government of Canada debt, an aggressive form of monetary policy called quantitative easing (QE). The central bank’s holdings of federal debt climbed to about $425 billion during the crisis, from around $100 billion at the start of 2020. The Bank of Canada intends to use the proceeds of maturing securities to continue purchasing securities, but will no longer create money to do so.

Bay Street wasn’t overly surprised by the decision to end QE, because it had become clear that the economy no longer required emergency stimulus. The Bank of Canada acknowledged as much, describing current growth as “robust,” while noting that strong hiring in recent months had “significantly reduced the very uneven impact of the pandemic on workers.”

Fewer investors anticipated the shift in the Bank of Canada’s guidance for when it expects to raise the benchmark interest rate from its current setting of 0.25 per cent. Policy-makers advanced the timing to  “sometime in the middle quarters of 2022,” suggesting that borrowing costs could rise as soon as April, compared with previous guidance of sometime in the second half of next year.

The central bank’s pivot caused the price of two-year Canadian debt to plunge, raising yields by as much as a quarter of a percentage point, which could result in a repricing of the currency and various debt securities. The value of the dollar jumped a cent to 81 cents U.S.

“That’s tightening by the market that wasn’t there yesterday,” said Tom O’Gorman, director of fixed income at Franklin Templeton Canada. Macklem, he added, “sounded like he was bending over backwards to assure everybody that inflation is going to return to its trend next year.”


Policy-makers have always said the timing of interest-rate increases is tied to their outlook, not the calendar, and the new forecast suggests demand will run up against the limits of the economy’s ability to generate non-inflationary growth sooner than previously thought.

That’s not an entirely positive realization. The Bank of Canada predicts the economy will expand 5.1 per cent this year, slower than previously thought, but still strong by historical standards.

But the main reason the “output gap” is closing faster than expected is because the central bank now estimates Canada’s economy can only grow at a rate of about 1.6 per cent before capacity constraints spark inflationary pressures — about one percentage point slower than before the pandemic.

© Provided by Financial Post

“Shortages of manufacturing inputs, transportation bottlenecks, and difficulties matching jobs to workers are limiting the economy’s productive capacity,” the Bank of Canada said in the policy statement.

Canada’s central bank sets interest rates to keep the consumer price index (CPI) advancing at an annual pace of about two per cent. The Bank of Canada’s new forecast sees inflation getting back to target at the end of 2022, but not before it surges to an uncomfortably fast rate of about 4.8 per cent over the four quarters.

Macklem has said he would be willing to tolerate a certain amount of inflation to speed the recovery from the COVID-19 recession. However, a forecast that showed year-over-year increases in the CPI could breach five per cent would have been more than the central bank’s leaders could stomach.

Central bankers believe inflation can become a self-fulfilling prophecy if businesses start raising prices and workers begin insisting on higher wages because they think higher costs will persist. The Bank of Canada is generally comfortable as long as inflation stays within a zone of one per cent to three per cent. Year-over-year growth in the CPI breached the top end this summer and hasn’t dropped back.

“It is our job to bring inflation back to target, and I can assure you we will do that,” Macklem said at his quarterly press conference, the governor’s first in front of a live audience since taking over the Bank of Canada in June 2020.

The Bank of Canada now forecasts the CPI to increase 3.4 per cent this year, 3.4 per cent next year (compared with a previous estimate of 2.4 per cent) and 2.3 per cent in 2023, little changed from the July outlook. That extra bit of above-target inflation two years from now is intentional, as Macklem stressed that he remains committed to orchestrating a strong recovery from the COVID crisis.

The jobless rate was 6.9 per cent in September, compared with about 5.5 per cent ahead of the recession. Total hours worked remain well below pre-pandemic levels, and low-wage workers are trailing behind the employment rates of most everyone else.

“Slack remains in the labour market,” the governor said. Still, the threat to the economy that he wanted to emphasize was unquestionably inflation. “If there are new developments pushing inflation away from our target, yes, you can absolutely expect that we will continue to be adjusting our policy settings to be sure we get inflation back to target,” he said.

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