Today, the Bank of Canada increased its overnight interest rate to 5.00% (+0.25% from June) because of the “accumulation of evidence” that excess demand and elevated core inflation are both proving more persistent and after considering its “revised outlook for economic activity and inflation.”
This decision was not unexpected by analysts but is disconcerting – as is the Bank’s pledge to continue its policy of quantitative tightening.
To understand today’s decision and the Bank’s current thinking on inflation, interest rates, and the economy, we highlight its latest observations below:
In Canada, Consumer Price Index (CPI) inflation eased to 3.4% in May, a “substantial and welcome drop from its peak of 8.1% last summer”
While CPI inflation has come down largely as expected so far this year, the downward momentum has come more from lower energy prices, and less from an easing of “underlying inflation”
With the large price increases of last year removed from the annual data, there will be less near-term “downward momentum” in CPI inflation.
Moreover, with three-month rates of core inflation running around 3.5% to 4% since last September, “underlying price pressures appear to be more persistent than anticipated”, an outcome that is reinforced by the Bank’s business surveys, which found businesses are “still increasing their prices more frequently than normal”
Global inflation is easing, with lower energy prices and a decline in goods price inflation; however, robust demand and tight labor markets are causing persistent inflationary pressures in services.
Canada’s economy has been stronger than expected, with more momentum in demand. Consumption growth was “surprisingly strong” at 5.8% in the first quarter. While the Bank expects consumer spending to slow in response to the cumulative increase in interest rates, recent retail trade and other data suggest more persistent excess demand in the economy. The housing market has seen some pickup.
New construction and real estate listings are lagging in demand, which is adding pressure on prices. In the labor market, there are signs of more availability of workers, but conditions remain tight, and wage growth has been around 4-5%. Strong population growth from immigration is adding both demand and supply to the economy: newcomers are helping to ease the shortage of workers while also boosting consumer spending and adding to the demand for housing.
Economic growth has been stronger than expected, especially in the United States, where consumer and business spending has been “surprisingly” resilient.
After a surge in early 2023, China’s economic growth is softening, with slowing exports and ongoing weakness in its property sector. Growth in the euro area is effectively stalled: while the service sector continues to grow, manufacturing is contracting.
Global financial conditions have tightened, with bond yields up in North America and Europe as major central banks signal further interest rate increases may be needed to combat inflation. The Bank’s July Monetary Policy Report projects the global economy will grow by “around 2.8% this year and 2.4% in 2024, followed by 2.7% growth in 2025” .
As higher interest rates continue to work their way through the economy, the BoC expects economic growth to slow, averaging around 1% through the second half of 2023 and the first half of next year. This implies real GDP growth of 1.8% in 2023 and 1.2% in 2024. The Canadian economy will then move into “modest excess supply” early next year before growth picks up to 2.4% in 2025.
In its July Monetary Policy Report, the Bank noted that CPI inflation is forecast to “hover” around 3% for the next year before gradually declining to 2% in the middle of 2025. This is a slower return to the target than was forecast in its January and April projections. As a result, the Bank’s Governing Council remains concerned that progress towards its 2% inflation target “could stall, jeopardizing the return to price stability.”
In terms of what Canadians can expect in the near term, the Bank had this to say: “Quantitative tightening is complementing the restrictive stance of monetary policy and normalizing the Bank’s balance sheet. The Governing Council will continue to assess the dynamics of core inflation and the outlook for CPI inflation. We will be evaluating whether the evolution of excess demand, inflation expectations, wage growth, and corporate pricing behavior are consistent with achieving the 2% inflation target. The Bank remains resolute in its commitment to restoring price stability for Canadians.