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Canada’s central bank raised its key interest rate by 75 basis points in a effort to pull inflation back from its highest level in decades. Greg Bonnell speaks with Leslie Preston, Senior Economist at TD Bank, about the impact of higher rates and the looming threat of a recession.
Transcript
Greg Bonnell: Bank of Canada delivering another super-sized rate hike, raising its overnight benchmark by 75 basis points. We’re now at 3.25%. Of course, the big question is, where do we go from here? Let’s take a look what it all means for inflation, the economy, and the future borrowing costs. Senior Economist Leslie Preston joins us now. Great to have you with us, Leslie.
Leslie Preston: My pleasure.
Greg Bonnell: All right, so let’s start there. I know TD Economics has a new call out. We got the 75 basis points today. And people want to know, are there more to come?
Leslie Preston: We do think there are more to come. It was a pretty hawkish message, overall, from the Bank of Canada today. And we do expect the bank to take the overnight rate to 4% by the end of the year.
Greg Bonnell: By 4% by the end of this year. So we’ve got another 75 basis points to go. After that, what kind of situation is the bank going to be in? I mean, getting to that 4% rate, that’s pretty dramatic considering where we started this year and where the call is to end up this year. What happens in 2023?
Leslie Preston: We think the Bank of Canada will take a long pause as it really assesses how the Canadian economy is digesting these higher borrowing costs. Central banks have been burned in the past by giving up the fight on inflation too quickly. I know some people in markets think that there could be cuts next year. We think, barring a recession, that the bank will be in for a long period of holding rates steady.
Greg Bonnell: Yeah, the idea that they’re not going to blink, even though, as we’ve heard, there’s going to be some pain for us as Canadians. I want to go through that statement because you talked about the hawkishness of it and sort of start breaking down some of the areas because, of course, they had to recognize, when it came to inflation, the main message here, what they’re trying to fight, yeah, we did see headline inflation ease in July. There was a caveat, though. However, they start talking about some of the underlying components. And so how is it playing out, in terms of — okay, headline inflation eased. But as we go into the surface, we know there’s some stickiness.
Leslie Preston: Exactly. In fact, the Bank of Canada tracks three core inflation measures. And we saw, on average, those three measures actually increased. Core inflation increased in July. So it’s great that headline is coming down on lower energy prices. Even since the July report, we’ve all been seeing lower prices at the pump. But those underlying inflation metrics that the bank watches are around 5%, just above 5% year-on-year, a lot higher than they want them to be and moving in the wrong direction. And the bank called that out in their statement, and particularly pointing to services inflation. Canada’s economy grew very strongly in the first half of the year. And it’s not surprising that services inflation has picked up.
Greg Bonnell: Yeah, I think it was TD Economics, earlier this week, had a pretty interesting piece on the fact that, okay, you get inflation. And you want to strip out the volatile elements, energy and food — although I’ve never truly understood that because that’s a big portion of my income going to energy and food. But they strip it out with this idea that once that inflation starts to go into the services side, that’s a stickier place. That’s harder to bring down.
Leslie Preston: Exactly. Services inflation has proved, over history, to be much more persistent. So as we see higher inflation in services more, that is what’s going to be tougher to bring down.
Greg Bonnell: And expectations as well. We central banks worry about this. And in the statement, that did talk about that survey suggesting that short-term inflation expectations remain high. Is that’s something the bank really needs to basically crush through its communications, that get us comfortable as Canadians that they can get this under control at some point?
Leslie Preston: Exactly. Expectations for inflation are key to the Bank of Canada’s mandate. They need to keep inflation expectations anchored in that 1% to 3% range. And so when they see that short-term inflation expectations were remaining higher than they would like, it’s exactly as you say. They need to act decisively, strongly, with a 75-basis point hike, to try to bring those inflation expectations back to where they would like them to be.
Greg Bonnell: Right, so they address inflation in the statement. They say, yes, the headline inflation came down. But important caveats that we just discussed, the Canadian economy. The economy grew at a pace not quite as robust, I guess, as the Bank of Canada had been penciling in. Yet again, there’s a caveat. But however, the Bank of Canada says, there’s other things to be looking at.
Leslie Preston: Yeah, the Bank of Canada is full of two-handed economists. Overall, the number for GDP disappointed a bit. But as they pointed out, the domestic demand indicators were very strong. Consumer spending was very strong. Canadians, without COVID restrictions by and large anymore, are out spending again. And those parts of the GDP report were pretty strong.
Greg Bonnell: Now, of course, the headline overnight rate, and the direction that it’s going to go on with TD Economics call. They’re going to hit 4 by the end of the year. That captures all the headlines because then people understand that. It flows directly into their household budgets, particularly if they have floating-rate loans. They talked a little bit about quantitative tightening, as well, and the job that that’s helping do in terms of eventually trying to cool the economy. Is there much going on in that space? I mean, how much does that actually contribute beyond the rate hikes that we’ve been seeing?
Leslie Preston: Well, the impact of quantitative tightening also acts to raise mid to longer-term term bond yields, which restrains growth in the economy. And the bank reiterated that its quantitative tightening program is ongoing. So to a certain extent, that it’s a bit of a substitute for rate hikes. So when we say 4% on the policy rate, the effect is actually slightly larger than that, given the impact of quantitative tightening.
Greg Bonnell: Now, when it comes to that kind of pain that we’ve been warned from central bankers, whether it’s ours, whether it’s Jerome Powell, south of the border, they say, we know that, in trying to wrestle inflation back to a 2% target and get it down there, there’s going to be pain for households. There’s going to be pain for the economy. What kind of pain should we be bracing for as Canadians?
Leslie Preston: Well, we think that growth in the second half of the year is going to be around 1% annualized in real terms. That’s pretty slow growth for the Canadian economy. Just by contrast, in the first half of the year, it was just above 3%. So we are calling for a pretty significant slowdown in growth and likely a rise in the unemployment rate. And again, putting that in perspective, Canada’s unemployment rate is at 4.9% in July. That’s more than a 50-year low. Basically, the job market in Canada has never been stronger. But as growth slows below what we would view as the economy’s trend growth rate or potential growth rate, we do think that there will be a rise in the unemployment rate.
Greg Bonnell: Now coming out of the financial crisis, we became accustomed as investors, or maybe just as households, as Canadians, that the central banks are going to ride to the rescue, that every time there seems to be a bit of trouble on the horizon, don’t worry. I mean, the markets for themselves could even have a bit of a tantrum. And it would seem that the central banks would ride to the rescue. Is it just a different game now? We’ve had the tough talk. We’re getting more of it today from our central bank. We’ve had it from south of the border. I think there’s probably still people out there who think they’re going to flinch, if we do end up with economic pain, if households are feeling the pinch, that they’re going to flinch. Do you think they’re serious this time?
Leslie Preston: I think they are. And to my point about the unemployment rate, ride to the rescue, I don’t think an economy with a 4.9% unemployment rate needs to be rescued. And I think that’s what the Bank of Canada has quickly been adjusting the settings of monetary policy for the strength of the Canadian economy. You’ve got inflation at a 40-year high, unemployment at a 50-year low. I think you could see a degree of worsening in unemployment before the bank is that worried about the unemployment rate. Just to give a bit more perspective on that, prior to the pandemic, the unemployment rate was around 5.8%, 5.9%. And we were calling that very low. So I think it’s just important to paint the backdrop as a very strong one for the Canadian consumer, dealing with much higher inflation rates and higher wage rates. So we do think that when you say, “the bank riding to the rescue,” I don’t think that would be needed unless they’ve tightened — they end up finding they’ve tightened too far and trigger a recession.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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