The Bank of Canada continued its tightening cycle last week by announcing a 75-basis-point increase in its overnight rate target. That target is now above the top end of the Bank’s estimate of the “neutral rate” of two to three per cent. But how fast will the rate go from here?
The neutral rate is the rate the Bank thinks would be appropriate for an economy producing at full capacity, with inflation running at two percent. Most economists and market-watchers believe the overnight rate needs to go beyond neutral in order to fight inflation. Despite a one-month drop in the year-over-year increase in the CPI from 8.1 per cent in June to 7.6 per cent in July, inflation is a long way above the top end of the one-to-three per cent target range, let alone the two per cent target itself.
There is much less consensus, however, on whether the Bank should continue to hike interest rates aggressively or take a more cautious approach. There are good arguments on both sides.
Arguing for a more aggressive approach: though GDP growth is slowing, it was still strong in the second quarter (3.3 per cent on an annualized basis) and running above its full capacity. And though headline inflation fell, two of the three core measures of inflation — which strip out the more volatile components of the CPI — ticked up in July, while the third, “CPI-trim,” barely budged. These core measures ranged from 5 to 5.5 per cent — well above the target range.
The drop in headline inflation was mostly due to gas prices, with other components of the CPI accelerating, particularly services. And these other components are what the Bank has control over, meaning it has a long way to go to bring inflation back down.
Arguing for a more cautious approach: the Bank’s previous rate hikes have clearly started to bite. Housing markets have already cooled considerably since the beginning of the year. Increases in monthly mortgage payments will only occur with a lag as many Canadians have either fixed rates or fixed payments. But increases are coming and will inevitably lead to belt-tightening by consumers, which will feed through to demand.
Moreover, the growth of monetary aggregates, measuring everything from cash to bank deposits to Canada Savings bonds, has slowed considerably in recent months. Over the last few decades, money has fallen out of favour with central banks as an indicator of future inflation. But, as we recently argued, it is a better predictor of future inflation when inflation is unsettled – as it is now. This slowing of money growth will likely damp inflation further down the road.
Finally, the arithmetic: The Bank’s target is year-over-year inflation, which largely reflects price increases that happened six months or more ago. Even if all consumer prices levelled off completely starting this month, headline inflation would remain above target until well into next year. The Bank’s monetary policy framework is designed to be forward-looking (i.e., to hit its target six to eight quarters down the road), which means it must look past year-over-year inflation numbers, analyzing what month-over-month numbers are saying as well. The drop in the latest month-over-month number was driven by energy prices but it did come in below an annualized two per cent.
The Bank has come down on the side of significant front-end loading of interest rate increases, and the announcement that accompanied last week’s rate hike suggests more increases are to come. One reason the Bank has avoided even larger hikes is that getting inflation back to target is an inexact science. It is prudent to see how the economy reacts to what has been a significant change in rates over a short time.
The announcement discusses the many reasons why the Bank tightened as much as it did, but to us one rationale stands out — inflation expectations. In July’s Monetary Policy Report the Bank estimated inflation would return to the top end of the target range (i.e., three per cent) by the end of 2023 and return to target by the end of 2024, or in roughly two years. But the latest Bank data on two-year-ahead inflation expectations, compiled in the Business Outlook Survey for the second quarter, suggests almost 80 per cent of respondents think inflation will remain above three per cent at that time.
The third-quarter survey on expectations, which is due in mid-October, will be a good indicator of whether the two most recent rate hikes — totalling 175 basis points — have changed the expectations calculus. If expectations are down and if the actual inflation numbers for August — both year-over-year and month-over-month — show broad indications of cooling, it will be time to slow down rate hikes. Otherwise, the Bank will have to maintain or even pick up the pace.
Steve Ambler, a professor of economics at the Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is director, monetary and financial services research.
Published in the Financial Post