The Bank of Canada raised its key interest rate by 100 basis points to 2.5% in an attempt to curb inflation, which, according to politicians, may take hold.
Wednesday’s gain was the biggest in Canada in more than two decades and took markets by surprise, which were expecting a 75bp gain. It sets the base overnight rate at its highest level since 2008. Inflation, which stood at 7.7% a year before May, is now almost four times the central bank’s target of 2% and is the highest level since 1983.
The move follows news that US inflation hits 9.1 percent during the year to June, raising the likelihood of a US Fed rate hike of at least 75 bps. at the end of this month.
The Central Bank of Canada said he wanted to “load” the rate hike as inflation appeared to be “higher and more resilient” than they noted in their April monetary policy report and “likely to remain” at around 8 percent for the next few months.
“Cycles of forced tightening tend to come with softer landings,” Bank of Canada Governor Tiff Macklem said at a press conference on Wednesday.
“We are well aware that higher interest rates will affect Canadians who are already suffering from high inflation. . . but by increasing the cost of borrowing, we will moderate spending and bring inflation back to its target.”
Macklem said the central bank is aiming for a so-called soft landing, where it quells scorching inflation without triggering a recession. But he noted that the path is narrowing because the rise in prices proved to be more resilient than expected.
“Consumers and businesses expect inflation to be higher for a long time, which raises the risk that higher inflation will take hold in pricing and wage setting,” the bank said in a statement. “If that happens, the economic cost of restoring price stability will be higher.”
The move comes amid growing recession fears in Europe and North America as central bank rate hikes and rising energy prices are expected to dampen economic growth.
Last week, RBC became the first Canadian bank to predict a recession in the country in 2023. The central bank did not forecast a recession in its base case, but expects gross domestic product growth to slow to 1.8% next year.
Inflation could trigger a recession if a price-wage spiral occurs when high prices push it higher, the Bank of Canada said in a monetary policy report posted on Wednesday.
“To break the vicious circle, monetary policy aims to tie long-term inflation expectations to a 2 percent target,” the report said. The bank predicts that it will reach its inflation target by the end of 2024.
Macklem also expressed optimism that Canada’s resource-intensive economy will buffer a global slowdown as many exported goods continue to have elevated prices.
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Responding to questions about the bank’s miscalculation in the fall that inflation was “temporary,” he pointed to global factors beyond his control, including “significantly higher oil prices” and tangled global supply chains.
Another reason for the error was the country’s rapid recovery from the coronavirus pandemic, Macklem added. As rates in Canada remained close to zero, people saw their savings skyrocket, wages soar, and house prices continued to rise, peaking in February.
Wednesday’s rate hike followed a 50 basis point increase in April and June and a 25 basis point increase in March. This has cooled Canada’s hot housing market by raising mortgage rates, but the job market remains tight. The unemployment rate fell to a record low of 4.9% in June. Employers report difficult employment conditions, with workers demanding higher wages.
More action is expected in the coming months.
“We are now forecasting a 50 basis point gain in September and October and a 25 basis point gain in December,” said James Knightley, an economist at ING Bank. “But the odds are certainly moving in the direction of a more aggressive move, at least in September, especially if inflation shows no signs of slowing down.”