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The Bank of Canada has been aggressively hiking rates to battle inflation. Andrew Kelvin, Chief Canada Strategist, TD Securities, tells Greg Bonnell why he thinks rates could go higher than previously forecast.
Greg Bonnell: The battle against inflation remains the Bank of Canada’s top priority at the moment. And with higher prices showing very little signs of cooling, Central Bank has made it clear it’s going to do whatever it takes to get the job done. Well, my next guest says that could include interest rates climbing to as high as 4%. That is higher than the previous forecast from the shop.
Andrew Kelvin, Chief Canada Strategist at TD Securities. Andrew, great to have you back on the show. You got a fresh call about basically what’s called the terminal rate, how far this bank needs to get before the job is done.
Andrew Kelvin: Yeah, thank you for having me. The Bank of Canada at their last meeting on September 7th, their forward guidance was very, very open ended, but it had a distinctly hawkish tone to it. It suggests, to me at least, that the Bank of Canada doesn’t necessarily have a firm idea where the end point of this cycle is going to be. Or if they do, they’re not willing to share because they want to keep all their options open.
Sort of necessarily, if they’re telling you they’re not sure if they’re close to being finished or not, it implies a risk of a much higher end point for rate hikes this cycle. So we had previously been looking for the bank to finish their tightening cycle at 3.5%. It now looks to us that 4% is probably a more likely level. And I think, realistically, you can think about anything from 3.5% all the way up to 4.5% or 4.75% as a plausible endpoint for the Bank of Canada, though anything above 4% would be quite aggressive given the disposition of the Canadian economy.
Greg Bonnell: Let’s talk about the disposition of the Canadian economy, because obviously with the last rate hike they entered to what, by their own metrics, we’d consider restrictive territory, where we should start seeing some people pull back with borrowing costs as high and perhaps an impact on the economy. So I have to go much further than that. What does it tell us about inflation? What does it tell us about the estate of the Canadian economy?
Andrew Kelvin: So inflation is the Bank of Canada’s main priority, as you noted. The Bank of Canada’s one job is to bring inflation lower, and they have been underestimating the strength of inflation for several years now. They underestimated the strength of the economy coming out of the pandemic. I think if you go back to the early part of this year, the bank was concerned that with some of the lingering COVID waves we’d see a slower Q1, and that never materialized.
Part of growth being stronger than expected, we also had supply chains which were problematic longer than expected. The Bank of Canada had anticipated that supply chains would resolve themselves. Now, these were very difficult calls to make in the moment, but the fact remains inflation’s been high for quite some time. It’s starting to seep into longer-term inflation expectations.
That’s the fear, at least, because I’m sure most people, when you speak to people on the street, there’s a perception that inflation is very high. And if people believe that inflation will remain high over a long period of time, it makes the Bank of Canada’s job much more difficult. So what they’ve done is they are moving not just into restrictive territory quite quickly, which they did.
We had 175 basis points of tightening over two meetings, which is an extraordinarily rare thing for Central Bank to do. They’re unlikely to go a little bit further this cycle just to really ensure that the job is done, to really ensure that they will be able to bring inflation back down to target, despite the fact that we’ve had three months of job losses now.
The economy is showing signs of slowing. Normally, the Bank of Canada would see these signs of slowing, take a little bit of a pause. And in a more normal cycle, I might look at the growth figures. I might look at the jobs and say, OK, this is the top. But because the Bank of Canada was behind the ball early this year, late last year, they now may need to go a little bit further in bringing inflation under control.
Greg Bonnell: So when it comes to rates, how much further they need to go, you got a picture for us? A chart? We’ll throw it up on the screen for the audience, and walk us through it. What is this telling us?
Andrew Kelvin: So what I’ve done here– I think there’s sort of two points. So the darker bar there, that is the market expectation for where the Bank of Canada will go. And you can see the market really firmly expects in basis points– so 48 basis points. The market’s fully pricing in, essentially, a 50 basis point move in September.
Where I differ a little bit– and this is as much a rhetorical tool as anything. I think now that we’re at a pretty high level of interest rates relative to where we’ve been in the past 15 years. And given that the economy doesn’t look like it did in 2004-2005– the economy is experiencing quite a bit more leverage, is going to be more sensitive to interest rate hikes– I think it would be prudent for the Bank of Canada to move just a little bit more cautiously to that 4% target so that if the rate hikes have unanticipated consequences, they haven’t overtightened to an extent that maybe they would not want to.
The other point I would raise on that chart–
Greg Bonnell: Yeah, because you get further out, and I think I’m seeing forecasts for a cut.
Andrew Kelvin: That’s exactly it. The fact that the bank is tightening to this extent to bring inflation expectations under control, if they’re successful at this, which I expect they will be– and if we go to– let’s call it the third quarter of next year, because that’s when we have it penciled in– they might be looking at an economy which has seen the unemployment rate rise by a percentage point or perhaps more, an economy where inflation’s come lower, because we do think we’ve seen the peak in inflation, and an economy where inflation expectations are becoming well anchored again.
They could ask themselves or say to themselves, do we really need to be at 4% still, which is a firmly restrictive policy rate? So I think there’s scope in the second half of next year for the Bank of Canada to start removing some of the tightening they’ve put in. It’ll be a more gradual process. It’s not going to be symmetrical. They’re not going to be cutting by 100 or 75 basis points per meeting, we believe.
But we could start to see some gradual easing in the second half of next year, which would get us something a little bit more normal hopefully by end of 2024.
Greg Bonnell: Of course, the Bank of Canada is not acting in a vacuum here. There was a whole chorus of global central banks, with the exception of China, who are on this path as well. At what point could Canada diverge from the United States? Are the dynamics different enough that maybe the Fed keeps going but the Bank of Canada realizes we’ve gone about as far as we can go given our economic conditions? I’m thinking about debt again.
Andrew Kelvin: Yeah, that’s a really good point. I would say, just in a vacuum, if you put the same set of challenges in front of the Federal Reserve as the Bank of Canada, there’s more room for the Federal Reserve to tighten. And that goes back to that household debt issue. Over the last– through the whole post-financial crisis period, Canadian households have continued to add leverage, add leverage, add leverage.US households started a long deleveraging process after the financial crisis in ’09. And as a result, Canadian households have 80% more leverage measured by debt-to-income than US households, and that should make each rate hike in Canada more impactful than a rate hike would be in the US. So with that in mind, I do think there’s scope for the Fed to tighten more than the Bank of Canada.
We think the Federal Reserve could get all the way to a 4.5% as the top end of their band, whereas we think the Bank of Canada tops out at 4%. Having said all that, the Bank of Canada can’t diverge too far from the Fed. Now, last cycle the Bank of Canada finished 75 basis points below the Fed. Over time, those two central banks do tend to move together.
And if the Bank of Canada were to fall too far behind the Fed this cycle, that would have implications for the currency. The currency would weaken. That would have short-term inflationary implications, which the Bank of Canada would not especially like. It’s not their main priority. It’s not their second priority. But it does impact things on the margin.
And I think there would also be a sense, given that Canada and the US are facing the same shocks– these are demand shocks. If the Fed gets too far ahead of the Bank of Canada, it would raise questions if the Bank of Canada is taking things seriously, and it goes back to this credibility question. The Bank of Canada is not in the position to be disappointing markets, and they’re not in a position to be inviting questions about their commitment.
Greg Bonnell: Central bankers have said, including ours, they’re not trying to break something. We’re hearing this phrase. They’re going to continue tightening until something breaks. Can they avoid that now? That’s sort of seems to be the point. As you mentioned, we can’t fix supply chains or some of these other issues with higher rates, but we sure can tamp down demand.
Andrew Kelvin: Yeah. The point is to slow growth. It’s a tricky thing for a central bank to say– it’s extraordinarily difficult for a central bank to come and say, what we would like to do is lift the unemployment rate. That’s politically not a feasible thing for any sort of policymaker to make. But that is how monetary policy tightening works on some level.
What they’d like to do is engineer what’s called a soft landing. Now, there’s no technical definition of a soft landing. We could argue all day about what it means. It’s not especially helpful a debate. But that’s sort of the middle path they’d like to go down here. The problem is, because they have fallen behind the curve, as it were, in the early part of the year and they’re now trying to make up by hiking by leaps and bounds with these 75, 100 basis point moves, it just makes the risk of an overshoot that much greater because monetary policy works with a lag.
Rates don’t go up one day and inflation falls the next. It takes a year, a year and a half for these effects to be fully felt. So given that they are focused on bringing inflation under control, given that they’re probably willing to err on the side of overtightening a bit, I think a soft landing is still possible, however you define that. It just becomes a much, much, much more difficult thing to achieve when you need to be lifting rates in such a rushed fashion.
Which is why I go back to this idea that I think the most prudent thing for them to do would be to slow down to a more measured pace of tightening going forward.
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