Yahoo Finance Bank of Canada holds interest rate, but get ready for higher for longer
The Bank of Canada left its benchmark interest rate unchanged and released updated forecasts that suggest Canada will avoid a recession, although the unexpected strength — the result of pent-up demand for services and a surge in government spending — is complicating policymakers’ efforts to get inflation back to their target of two per cent.
“Getting inflation the rest of the way back to (two per cent) could prove to be more difficult because inflation expectations are coming down slowly, service price inflation and wage growth remain elevated, and corporate price behaviour has yet to normalize,” the Bank of Canada said in its policy statement, released April 12.
Also: “Governing Council continues to assess whether monetary policy is sufficiently restrictive to relieve price pressures and remains prepared to raise the policy rate further if needed to return inflation to the (two per cent) target.”
In other words, prepare for interest rates that are high — or higher — for longer.
Here’s what you need to know:
Growth was much hotter in the first quarter than the Bank of Canada anticipated at the start of the year. Its updated forecast predicts gross domestic product grew at an annual rate of 2.3 per cent through March, compared with a January forecast of 0.5 per cent. The central bank predicts growth of one per cent in the current quarter.
For the year, the Bank of Canada now says GDP will expand 1.4 per cent this year, up from one per cent in January, and 1.3 per cent in 2024, down from its previous forecast of 1.8 per cent. (Growth was 3.4 per cent in 2022.)
Inflation is coming down but could get sticky. The Bank of Canada forecasts that year-over-year changes in the consumer price index will average 3.3 per cent in the second quarter, but inflation still will be at 2.5 per cent at the end of the year. (The target is two per cent.)
The economy will move into “modest excess supply” in the second half of 2023; in other words, that’s when the Bank of Canada expects demand will stop exerting outsized upward pressure on inflation.
For now, the economy exhibits what the Bank of Canada calls “excess demand.” Its measure of the output gap – the difference between actual output and the amount of goods and services the central bank thinks the economy can generate without stoking inflation – will be 0.25 per cent to 1.25 per cent in the third quarter.
The Bank of Canada updated its estimate of Canada’s non-inflationary growth rate to about two per cent, an improvement from 1.4 per cent in 2022, but down considerably from its previous estimate of about three per cent.
Surprises
Prices of financial assets tied to short-term interest rates suggest some investors are preparing for cuts by the end of the year. There’s no hint of any of that in the Bank of Canada’s forecast or guidance. The forecast shows the economy is stronger than policymakers were expecting, suggesting the central bank might yet achieve a “soft landing” from elevated levels of inflation and unsustainably fast growth.
But that forecast also shows that getting inflation all the way back to the target — which governor Tiff Macklem has said he intends to do, no matter what – could require a difficult push at the end. The outlook has year-over-year increases in the consumer price index slowing to about three per cent by the second half of 2023 but getting hung up at 2.5 per cent at the end of year.
If that’s how things unfold, it’s hard to imagine interest cuts will be on the table before sometime in 2024.
Inflation
The Bank of Canada has been slicing the price data to get a read on the sources of inflation. The good news: when measured as a three-month moving average, inflation has slowed to about 1.6 per cent – suggesting prices pressures are receding. Additional good news: the central bank ran some calculations that suggest grocery prices are about to drop, assuming recent historical patterns still apply.
The bad news: the cost of services isn’t falling, probably because there still is lots of pent-up demand from being denied travel and restaurants during the pandemic, and providers of such services are struggling to find workers. The Bank of Canada reckons “core” services inflation, excluding costs associated with shelter, was still growing at an annualized pace of about six per cent, when measured on a three-month basis.
“For CPI inflation to return sustainably to the two per cent target, core inflation will need to come down further,” the central bank said in its economic update.
Wage growth is a problem
It hasn’t attracted a lot of attention, but average wages are now increasing faster than headline inflation. That shift doesn’t mean millions of people are suddenly better off, given the cost of food and shelter remains high. But at an aggregate level, it does mean wages are becoming a more important source of inflation.
The Bank of Canada maintains that wage increases are inflationary when they exceed productivity growth. That’s because higher incomes are adding to demand at a rate that’s faster than companies are increasing their ability to supply that demand.
“Unless a surprisingly strong pickup in productivity growth occurs, sustained (four per cent) to (five per cent) wage growth is not consistent with achieving the (two per cent) inflation target,” the report said.
The Bank of Canada’s new forecast for trend productivity growth through 2026 is about one per cent.
No recession
They said it couldn’t be done.
When central banks around the world lost their grips on inflation, and responded by jacking up interest rates, many economists predicted a recession was inevitable. Macklem and his peers acknowledged the possibility, but insisted there was a narrow path to a “soft landing.” The Bank of Canada’s forecast suggests they found it.
In Canada’s case, outsized levels of immigration appear to have provided a cushion, offsetting the impact to higher interest rates on demand. Government spending also provided a boost – perhaps even too much, as policymakers described public spending as “robust” over the second half of 2022.
“Over the projection horizon, government spending will contribute steadily to GDP growth, with the biggest contribution coming from provincial spending,” the quarterly economic outlook report said.
The term “soft landing” implies something gentle. It probably doesn’t feel like that for the thousands of people in technology and other industries that are downsizing in anticipation of slower growth and more expensive capital over the next year or so. And there still could be negative quarters of GDP growth, as the Bank of Canada’s outlook has growth in the Unites States dropping significantly, business investment stalling for the next two years, and higher mortgage rates weighing on consumption.
Growth of about one per cent is better than zero or negative, but it might not feel like it.
• Email: kcarmichael@postmedia.com | Twitter: CarmichaelKevin
