Faced with Stubborn Inflation, the Bank of Canada Maintains its Key Rate at 5%

- Mario Conte - November 17, 2023

Higher interest rates have had an impact on the economy and inflation, although more slowly than expected, acknowledges the Bank of Canada, which is staying the course for the moment and even promising to raise rates again if necessary .

As expected, the bank of Canada left its key rate unchanged at 5% on Wednesday, marking the second time in a row. Faced with galloping inflation, it has already raised rates 10 times since March 2022, taking them from 0.25% to their current level, the highest since April 2001.

The Bank of Canada estimates that in the range of 2% to 3%, its key rate has a neutral effect on household consumption and business investment. Below this range, its monetary policy stimulates them; above, it slows down demand (and therefore, price growth).

“Inflation has fallen significantly since the summer of 2022, but as everyone knows, it is still too high,” Bank of Canada Governor Tiff Macklem said when announcing the decision to the establishment and presentation of a new overview of the situation.

"We have kept the policy rate at the same level because monetary policy is slowing the economy and easing price pressures, and we want to give it time to do its job. However, the decline in inflation is expected to continue slowly , and inflationary risks have increased."

Hard to handle

As a sign of the slowness of its fight against inflation, the bank of Canada has been forced to revise its inflation forecasts upwards since July. Although she still expects the cost of living to return to its 2% target by 2025, she acknowledges that inflation will likely remain higher than she thought, averaging approximately 3.5% by mid-next year.

Nevertheless, there have been improvements. Rising from 8.1% in June 2022, the annual increase in the consumer price index has fluctuated between 2.8% and 4% in recent months.

Price increases for interest-rate-sensitive goods, such as furniture and appliances, as well as other items such as clothing and shoes, have already returned to 2% or less. Although still high, food inflation is now at 6% and is expected to continue to fall.

On the other hand, housing costs continued to rise, reaching an increase of 8% over three months, due not only to interest rates from the Bank of Canada, but also to chronic supply shortages by relationship to demand. Gasoline prices have also resumed their rise due to the rise in global oil prices.

Wage growth remains strong (between 4% and 5% year-on-year), and companies continue to raise prices more frequently and more substantially than before, meaning that core inflation has only fallen. only slightly, falling from just over 5% in 2022 to just under 4% in the middle of this year.

The “R” word

The increase in interest rates by the bank of Canada and around the world is already having an impact on economic strength. According to the Bank of Canada, Canadian economic growth averaged just 1% over the past year and is expected to remain weak for at least another year before rebounding toward the end of 2024.

With such weak economic growth, it should not be surprising if Canada experiences "two or three slightly negative quarters," Tiff Macklem said at a press conference.

However, this does not necessarily mean "the sharp decline in output and significant increase in unemployment that people think of when they hear about a recession."

"It has long been said that the path to a soft landing will be narrow. And that path has become even narrower," he added, while expressing his willingness to raise the policy rate again if inflation fundamental does not show signs of returning towards the 2% target.

Governments in Canada could help their central bank by avoiding stimulating demand in excess of available supply. However, this could be the case next year if their spending and investments follow their promises (+2.5%). “It would be easier if monetary policy and fiscal policy went in the same direction,” the governor noted.

When will rates drop?

One thing is certain: the Bank of Canada will not start cutting interest rates until it is convinced that inflation is on track to return to its target, Tiff Macklem said. And the possible impact of new tensions between Israel and Hamas on oil prices is raising fears that this process will take longer than expected.

The rise in long-term interest rates in bond markets to levels not seen since 2007 suggests that Bank of Canada rates will remain high for a long time, observed TD Bank economist James Orlando in a brief analysis on Wednesday.

According to the latest survey from the Bloomberg news agency, economists forecast an initial decrease of 0.25 percentage points in the second quarter of 2024, noted Randall Bartlett of Desjardins Movement. However, in the latter scenario, a brief recession in the first half of the year is expected to force the Bank of Canada to cut rates much more quickly, from 5% to 3.5%. from the second quarter to the end of 2024. Growth is expected to weaken further in 2024, with real GDP rising by 0.9%, before rebounding to 2.5% in 2025.

The next announcement regarding the Bank of Canada's key rate is scheduled for December 6.

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