Sandrine Soubeyran
Robin Marshall
- BoC Tightening and Inflation Risks: The blog raises the question of whether the recent rate hike by the BoC may have been excessive, given the decline underway in Canadian inflation and signs the labour market is cooling.
- It explores the possibility the June and July tightening measures are designed as pre-emptive inflation insurance by the BoC...
- .... aimed at defusing risks of inflation expectations destabilising, given the lagged effects of monetary policy and extreme monetary stimulus in 2020-21.
The Bank of Canada has been fully transparent with its monetary policy since the Covid recovery, having promptly responded to inflation accelerating by raising rates, and switching from quantitative easing to quantitative tightening starting in Q2 2022 (Chart 1). But after two months of policy pauses and apparent success in cooling the economy, the BoC shocked markets by raising rates 25bp in June and a further 25bp in July, despite signs of economic softening. Why did the BoC feel the need to implement two small rate increases of 25bp in the last two months? Were these increases too far?
Chart 1. G7 central banks have started to desynchronise - Central bank policy rates
Source: Refinitiv; data as of July 13, 2023. Past performance is no guarantee to future results.Please see the end for important disclosures.
The BoC justified its first move, in June, on the basis the economy “was stronger than expected in the first quarter of 2023, with GDP growth of 3.1% and consumption growth was surprisingly strong and broad-based… [while] housing market activity has picked up. Overall, excess demand in the economy looks to be more persistent than anticipated”. The second move focused moreon “[slower] downward momentum in inflation” due to strong demand, household spending, population growth and accumulated household savings.
But by most measures and, also acknowledged by the BoC, the Canadian economy has since been slowing. This justified the BoC’s decision to pause policy in March and April after the interest rate increase in January this year, unlike other central banks, which continued to tighten policy. Rate hikes in the UK, Eurozone and US were deemed necessary, and well flagged (i.e., Eurozone), as inflation levels stayed stubbornly high, despite recent easing, though the UK was an exception, as inflation remained unchanged at 8.7% y/y since May, and core inflation accelerated.
But in Canada, CPI May inflation fell close to its 2% target, at 3.4% y/y, from 4.4% in April, and the BoC had indeed forecast the inflation rate to drop to “3% in the summer, as lower energy prices feed through and last year’s large price gains fall out of the yearly data”. Core inflation (ex-food & energy) also fell to 3.7% y/y (Chart 2). The recent sharp fall in US CPI inflation in June was also very encouraging.
Chart 2: Canadian inflation drops to around 3%, in line with the BOC estimates. Regional G7 inflation
Source: Refinitiv; data as of July 13, 2023. Past performance is no guarantee to future results.Please see the end for important disclosures.
Moreover, the Canadian bond market has been signaling recessionary risks since last June, as can be observed by the deeply negative spreads and deep yield curve inversions over the last twelve months in Chart 3. Both 10/2 and 20/2 yield curves have fallen well through -100bp, with 20/2s currently close to -150bp at the time of writing.
Chart 3: Deep curve inversions over the last 12M have highlighted recession risks too. Canada 10/2 & 20/2 Treasury spreads
Source: FTSE Russell and Refinitiv, data as of July 13, 2023. Past performance is no guarantee to future results.Please see the end for important disclosures.
Other macroeconomic measures have also confirmed Canada’s economic slowdown. Canadian wage inflation, while still robust, has eased (Chart 4), and although unemployment remains close to historical lows, the latest figure has also ticked up modestly, moving away from its lows.
Chart 4: Canadian wage inflation has slowed - Canada Wage Growth, Inflation and Unemployment Rates
Source: FTSE Russell and Refinitiv; data as of June 30, 2023. Past performance is no guarantee to future results.Please see the end for important disclosures.
Even so, the strength of domestic demand and consumption has remained a worry. As Chart 5 shows, retail sales, in value terms, bounced back strongly in May in absolute terms, though the broader trend appears to be stabilising. However, from a year-on-year perspective, the percentage change highlights a clear cooling as seen in Chart 6. Much of this appears to have been funded from the Covid windfall in savings, accumulated during the Covid lockdown (Chart 7). Other measures such as Canadian housing starts have also weakened.
Charts 5 and 6: Retail sales have stabilised and softened in 2023...
Source: Refinitiv; data as of July 12, 2023. Past performance is no guarantee to future results.Please see the end for important disclosures.
Chart 7...after the Canadian savings ratio mean-reverted to pre-Covid levels - Canadian household net saving
Source: Refinitiv; data as of July 12, 2023. Past performance is no guarantee to future results.Please see the end for important disclosures.
A BoC tightening too far?...
The weakening Canadian economy raises the question as to whether the latest 0.25% BoC rate rise this month may have been an increase too far and could send the economy into a deeper slowdown than necessary. After all, the Canadian economy does not have the same degree of labour market tightness, wage and price inflation as some G7 members, notably the UK. In addition, the BoC’s flexible inflation targeting regime allows the BoC flexibility in bringing inflation back to the 2% target over time[1] and includes an objective to maximise employment and preserve financial stability.
…or insuring against an inflation regime change
An alternative explanation is recent moves may represent an attempt to claw back some of the extreme monetary stimulus applied in 2020-21 and to defuse risks of inflation expectations de-stabilising. If monetary policy worked with no lag to affect inflation and output growth, this task would be more straightforward, and the BoC would have more room to wait and react if inflation expectations destabilised.[2] But estimates of the policy lag suggest this may be as long as one or two years, so a pre-emptive tightening becomes more necessary, if policy works with a lag, and there is a risk of inflation regime change.
[1] BoC inflation targeting regime.
[2] See “Monetary Policy Lag, Zero Lower Bound, and Inflation Targeting”, Shin-Ichi Nishiyama, BoC Working Paper, January 2009.
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