BoC walking a tightrope between fighting inflation and a slowing economy

The Bank of Canada cut its growth forecasts as it opted for an interest rate increase that was widely smaller than markets expected. REUTERS/Patrick Doyle (Patrick Doyle / reuters)

The Bank of Canada is having to walk a fine line between taming inflation that has persistently been above its two per cent target and mounting evidence that the economy is slowing.

In a press conference following the central bank's interest rate announcement Wednesday, governor Tiff Macklem acknowledged inflation is still too hot and that further rate hikes are needed, while also significantly lowering the Bank's growth projections for Canada and abroad.

"We're trying to balance the risks of under- and over-tightening," Macklem said.

"If we don't do enough, Canadians will continue to endure the hardship of high inflation. And they will come to expect persistently high inflation, which will require much higher interest rates and potentially a severe recession to control inflation. Nobody wants that. If we do too much, we could slow the economy more than needed."

Benjamin Reitzes, Canadian rates and macro strategist with BMO Capital Markets, says the Bank of Canada is taking into account economic risks that have heightened over the past few months.

"When they're already projecting that the economy's going to struggle through the middle of next year, they view that as a sign that maybe it's time to ease up a little bit at this point. That doesn't mean rate hikes are over. But the need for the types of aggressive moves that we saw in the prior couple of meetings are no longer necessary," Reitzes told Yahoo Finance Canada in a phone interview.

The Bank of Canada surprised the market with a half-point interest rate hike on Wednesday, bringing its key lending rate to 3.75 per cent.

If inflation stays higher, they will, I guess, to some extent regret what they've done todayBenjamin Reitzes, BMO Capital Markets

Most economists were expecting a larger three-quarter-point hike after ratcheting up their forecasts in recent weeks as September inflation data came in slightly hotter than expected at 6.9 per cent year-over-year and the central bank maintained its hawkish tone. RBC Economics was one of the main Bay Street firms that stuck with a prediction of a half-point hike, mostly based on the deteriorating economic backdrop.

The central bank is now forecasting GDP growth to be between zero and 0.5 per cent through the end of this year and in the first half of 2023 as the real estate sector softens, the job market shows signs of weakening and consumer spending pulls back.

Slower growth "provides the opportunity for supply to catch up and that will relieve price pressures," said Macklem.

The question though, Reitzes says, is whether that softening demand will be sufficient to bring inflation down.

"If inflation stays higher, they will, I guess, to some extent regret what they've done today," he said.

"It's pretty challenging to predict inflation at the best of times, let alone when things are as volatile as they are now. So it's a risk and there's a non-trivial chance that inflation will remain stickier and the Bank will have to raise rates even more than what they're expecting at this point."

Communication is key

Stephen Brown, senior Canada economist at Capital Economics, says after the Bank spent the last two months emphasizing the need for inflation and inflation expectations to come down, the Bank surprised the market with a half-point hike.

"It is hard to see much justification for the slower pace of tightening in the Bank's new forecasts either. Despite assuming a lower oil price than in July, the Bank still judges that inflation will be close to 3 per cent at the end of next year and only return to 2 per cent by the end of 2024," Brown said in a client note on Wednesday.

"The Bank instead seems to be growing more concerned about the downside risks of higher interest rates – both at home and abroad – to economic activity."

Capital Economics had previously forecasted an aggressive tightening of 75 basis points at this meeting, a half-point hike in December and quarter-point hike in January, which would've brought the overnight rate to 4.75 per cent.

Reitzes says the Bank of Canada has "not done the best job" at communicating to the market this time around.

"And this is not the first time this year that the Bank of Canada has surprised markets but [Macklem] said pretty clearly that they are probably debating between 25 basis points or 50 basis points at the next meeting and rates probably aren't going that much higher," he said.

BMO Capital Markets is currently forecasting a quarter-point hike at both the upcoming December and January meetings.

Michelle Zadikian is a senior reporter at Yahoo Finance Canada. Follow her on Twitter @m_zadikian.

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