We think market participants are getting ahead of themselves by pricing in an interest rate hike from the Bank of Canada in 2022, particularly as Governor Tiff Macklem again signalled yesterday that the Bank will place greater emphasis on employment outcomes than it has done in the past.
- We think market participants are getting ahead of themselves by pricing in an interest rate hike from the Bank of Canada in 2022, particularly as Governor Tiff Macklem again signalled yesterday that the Bank will place greater emphasis on employment outcomes than it has done in the past.
- The Bank’s forward guidance centres around its pledge to keep the policy rate at 0.25% “until economic slack is absorbed so that the 2% inflation target is sustainably achieved”. That marks a break from the past. When it raised rates in 2010, the Bank expected it to take six quarters for the output gap to close. In 2017, the Bank waited longer to act, but still hiked before the output gap closed and when inflation was only 1.0%. (See Chart 1.) The Bank tells us that it expects the output gap to close in early 2023 and inflation to settle at 2% later that year. (See here.) Following the sharp repricing so far this year, however, overnight index swaps now suggest the Bank will raise rates in the second half of 2022. Market participants seem to expect the Bank to raise rates sooner, and to a higher level, than the Federal Reserve. (See Chart 2.)
- Vaccinations are lagging the US and the government there is eyeing a much larger further fiscal stimulus than the Canadian government has planned. The recent rise in oil prices may help to narrow the gap, but our own and consensus forecasts envisage a somewhat slower economic recovery compared to the US. This suggests the difference in rate expectations reflects a view that the Bank will not be as willing as the Fed to let inflation run at more than 2%, presumably because the Fed has explicitly adopted an average inflation target and has also pledged to focus more on the employment part of its dual mandate.
- We think market participants are underestimating the degree to which the Bank will take a similar approach. The Bank may not officially change its framework to an average inflation target as part of the official five-year review this year, but it already has a 1% to 3% inflation target range that provides it with more policy flexibility than many central banks. Moreover, with both Canadian CPI and US PCE inflation averaging 1.6% since 2017, there is arguably just as much reason for the Bank to let prices “catch up”.
- Admittedly, the members of the Governing Council have been far less explicit than their US counterparts about the extent to which they are prepared to look through rises in inflation and instead focus on the labour market. But in his speech yesterday, Governor Tiff Macklem argued that “at its heart, inflation targeting is about achieving low inflation together with full employment” (our emphasis). Like his US counterpart has recently done, Macklem also focused on the disparate effects of the pandemic on different parts of society. Macklem also suggested that inflationary dynamics are less of a concern than the Bank has historically believed. Referencing low unemployment before the pandemic, he said “inflation wasn’t threatening to take off” and “as the pandemic recedes… we will keep that experience in mind”.
- We therefore continue to think the Bank will wait until 2023 to raise rates. One risk to our view is the housing market, which Macklem said is starting to display “excess exuberance”. This could raise the case for the Bank to end its bond purchases this year, rather than in 2022 as we expect, so that mortgage rates drift up. However, if we are right that bond yields will rise even as global central banks maintain their asset purchases, then it is likely that house price inflation will soon slow regardless. (See here.)
Chart 1: Number of Quarters Until BoC Expects Output Gap to Close & Policy Rate
Chart 2: Policy Rate Implied by OIS (%)
Sources: Bank of Canada, Refinitiv
Stephen Brown, Senior Canada Economist, +1 416 874 0514, email@example.com