The Bank of Canada is right to ease off the brakes to see what happens

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We expect – as most Canadians probably hope – that the bank will conclude that it has done enough

Tiff Macklem is the Governor of the Bank of Canada. The bank raised interest rates again last week but indicated it may pause rate hikes to assess the impact of higher borrowing costs on inflation. Photo by Blair Gable/Reuters Contents of the article

Steve Ambler and Jeremy Kronick

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The Bank of Canada met market expectations last week by raising interest rates by 25 basis points to 4.5 percent. The bank also shifted its tone from hesitant caution to cautious optimism. His message: The hikes could just be over.

In December, the bank made it clear that further tightening would depend on the data. This time she stressed that she would keep interest rates stable and pause to assess the impact of her cumulative rate hikes if inflation in key sectors eases at the rate she forecast in her last monetary policy report. A final spike of 4.5 percent would also be consistent with the CD Howe Institute Monetary Policy Council’s recent announcement.

We expect – as most Canadians probably hope – that the bank will conclude that it has done enough.

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For much of last year, it struggled against well-above-target inflation, peaking at 8.1 percent in June. The pace of rate hikes has been appropriately (and appropriately) remarkable. The challenge in this fight is always knowing when to stop. Monetary policy works with a time lag, both when the bank lowers its key interest rate and when it raises it. People don’t necessarily feel the effects of interest rate changes immediately, and it’s difficult to predict exactly when they will hit.

What makes us think that inflation will work its way back down to 2% without interest rates having to be raised again?

First, the Canadian government bond yield curve is inverted, as it has been since July, the month after inflation peaked: the yield on two-year bonds is higher than that on 10-year bonds. Inverted yield curves often indicate a slowdown in economic growth. Markets only tolerate low long-term interest rates if they assume that long-term inflation rates will also be low.

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Second, the bank’s rate hikes over the past year have already slowed spending on interest-sensitive items, including homes and cars, and the impact is spreading to other sectors like services and travel.

Third, because monetary policy works with a lag, it is always important to look at leading indicators. The OECD has a “Composite Leading Indicators Index” that combines a number of economic variables, including consumer confidence and business attitudes, that best predict turning points in the business cycle. Since May, the Canada index has both been below its long-term average and continued to decline. This indicates an impending burglary.

Fourth, monetary growth is declining, with broader money (M2++) growth at its lowest level since 2003, while narrower money (M1+) is actually contracting. When inflation is detached from its target, money supply growth becomes a good indicator of where prices are headed. Less money in the economy can dampen demand for goods and services, which helps reduce inflation.

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After all, as we have argued throughout these pages, the headlines or year-on-year inflation numbers are mostly old news. The last 6.3 percent in December includes monthly inflation in the first half of the year, which, as mentioned, peaked in June at 8.1 percent. More recently, the CPI actually fell 0.1 percent mom between November and December.

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A single month number can of course be a godsend. But the three-month annualized September-December inflation rate, while still high at 3.4 percent, was not far above the bank’s target range of 1 to 3 percent. The National Bank of Canada calculates a three-month core inflation rate that excludes not only food and energy but also mortgage interest costs. It was 2.4 percent in December and, more importantly, it was falling quickly.

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All major licensed Canadian banks are now forecasting real GDP to fall by at least a quarter this year. The Bank of Canada instead forecasts that GDP growth will “stagnate” through mid-2023, which could mean a quarter of negative growth will be offset by positive growth in the other quarter. Whatever the case, further rate hikes could push us into – or deeper into – a recession that everyone, including the bank, would like to avoid unless stalled growth isn’t enough to kick the wind out of inflation’s sails gain weight.

The Bank’s insistence that there are signs of inflation slowing is a welcome development, as is its wait-and-see approach, in our view. It is navigating the delicate balance between showing it is committed to bringing inflation back on target and assessing whether its rate hikes are now enough to get it there. We think it has the right balance.

Steve Ambler is Professor of Economics at the Université du Québec à Montréal and David Dodge Chair in Monetary Policy at the CD Howe Institute, where Jeremy Kronick is Director of Monetary and Financial Services Research.

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