Multiple inflation pressures complicate Bank of Canada's soft landing goal

By Fergal Smith

TORONTO (Reuters) - As the Bank of Canada opens the door to hiking interest rates above a neutral setting for the first time in 14 years, the goal of taming inflation without triggering a recession is challenged by the multiple drivers of price pressures and record-high household debt.

To tackle a three-decade high for Canadian inflation, the central bank says it will hike its benchmark interest rate toward the neutral rate, which it estimates to be between 2% and 3%, adding that it may need to lift rates above that range.

At neutral, interest rates are neither stimulating nor restraining economic activity, so a move above neutral could increase the risk of a hard landing, or sharp downturn for the economy - an outcome that central banks hope to avoid.

The BoC has not hiked above neutral since 2008 or earlier. It has published an update of its estimate for neutral every year since 2017, raising it last Wednesday by quarter of a percentage point.

"It may be a little bit harder to dock the boat, so to speak, than it has been over the last ten years," said Greg Anderson, global head of foreign exchange strategy at BMO Capital Markets.

"There are a lot of forces out there that are contributing to inflation and some of them may not be that temporary."

An aging workforce, the transition to a greener economy and moves to reduce economic interdependence between countries are among the long-term drivers of inflation, while temporary pressures include supply shocks related to the COVID-19 pandemic and the war in Ukraine. Canada's inflation rate was 5.7% in February.

The U.S. Federal Reserve has also signaled it could lift interest rates above neutral in the current tightening cycle. But Canada's economy is likely to be particularly sensitive to higher rates after Canadians ramped up borrowing during the pandemic to participate in a red-hot housing market.

Household debt is 186% of disposable income, a level that is the highest by far among G7 countries, data from the Organisation for Economic Co-operation and Development shows.

There's a big risk that asset markets such as the housing sector "end up collapsing as rates rise," said David Rosenberg, chief economist & strategist, at Rosenberg Research.

Last week, the BoC raised its benchmark rate by half of a percentage point to 1%, its biggest single hike in more than two decades, and said the economy is strong enough to handle further tightening.

Money markets are betting that the policy rate will climb to 3% next year, which would be the highest since 2008 and well above the 1.75% peak of the previous rate hike cycle in 2017 to 2018.

Still, the small gap between Canadian 2- and 10-year yields, at 35 basis points, is an indication that investors expect economic growth to slow. The flat yield curve comes as monetary policymakers globally turn more hawkish after potentially waiting too long to reduce pandemic-era support.

"The bottom line is (that) central banks ... overestimated the amount of stimulus that was required last year," said Darcy Briggs, a portfolio manager at Franklin Templeton Canada. "They overstayed their welcome."

(Reporting by Fergal Smith; Editing by Denny Thomas and Aurora Ellis)