The Bank of Canada ended its bond-purchase program and altered its timeline for when businesses and households should expect higher interest rates, as revised forecasts predict inflation will flirt with a rate of five per cent over the rest of the year.
“The main forces pushing up prices — higher energy prices and pandemic-related supply bottlenecks — now appear to be stronger and more persistent than expected,” Governor Tiff Macklem and his deputies said in a statement at the end of their latest round of policy deliberations on Oct. 27. “The bank is closely watching inflation expectations and labour costs to ensure that the temporary forces pushing up prices do not become embedded in ongoing inflation.”
Policy-makers said they would stop creating money to buy Government of Canada debt, an aggressive form of monetary policy called quantitative easing, or QE. The central bank’s holdings of federal debt climbed to about $425 billion during the crisis from about $100 billion at the start of 2020. The Bank of Canada intends to use the proceeds of maturing securities to continue purchasing securities, but will no longer be creating money to do so.
Bay Street won’t be overly surprised by the decision to end QE because it had become clear that the economy no longer required emergency stimulus. The Bank of Canada acknowledged as much, describing current growth as “robust,” while noting that strong hiring in recent months had “significantly reduced the very uneven impact of the pandemic on workers.”
Fewer investors will have anticipated the shift in the Bank of Canada’s guidance for when it expects to raise the benchmark interest rate from its current setting of 0.25 per cent, a pivot that could result in a repricing of the currency and various debt securities.
The central bank now expects to unpin its interest-rate target “sometime in the middle quarters of 2022,” suggesting that borrowing costs could rise as soon as April, compared with previous guidance of sometime in the second half of next year.
Policy-makers always said the timing of interest-rate increases was tied to their outlook, not the calendar, and the new forecast suggests demand will run up against the limits of the economy’s ability to generate non-inflationary growth sooner than previously thought.
That’s not an entirely positive realization. The Bank of Canada predicts the economy will expand 5.1 per cent this year, slower than previously thought, but still a strong rate of growth by historical standards.
But the main reason the “output gap” is closing faster than expected is because the central bank now estimates Canada’s economy can only grow at a rate of about 1.6 per cent before capacity constraints spark inflationary pressures — about one percentage point slower than before the pandemic.
“Shortages of manufacturing inputs, transportation bottlenecks, and difficulties matching jobs to workers are limiting the economy’s productive capacity,” the Bank of Canada said. “Although the impact and persistence of these supply factors are hard to quantify, the output gap is likely to be narrower than the bank had forecast in July.”
Canada’s central bank sets interest rates to keep the consumer price index (CPI) advancing at an annual pace of about two per cent. The Bank of Canada’s new forecast sees inflation getting back to target at the end of 2022 — but not before it surges to an uncomfortably fast rate of about 4.8 per cent over the four quarter.
Macklem has said he would be willing to tolerate a certain amount of inflation to speed the recovery from the COVID-19 recession. However, a forecast that showed year-over-year increases in the CPI could breach five per cent would have been more than the central bank’s leaders could stomach.
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Central bankers believe inflation can become a self-fulfilling prophecy if businesses start raising prices and workers begin insisting on higher wages because they think higher costs will persist. The Bank of Canada is generally comfortable as long as inflation stays within a zone of one per cent to three per cent. Year-over-year growth in the CPI breached the top end this summer and hasn’t come back.
“With inflation above the top of the bank’s inflation-control range and expected to stay there for some time, the upside risks are of greater concern” than factors that could impede economic growth, the Bank of Canada said in its quarterly outlook.
“While the bank elevated inflation as transitory, the realization of additional upside risks or unanticipated persistence of existing pressures could lead to a rise in inflation expectations along with more pervasive labour cost and inflationary pressures,” policy makers said. “The risk is that these effects begin to feed into embedded inflation.”
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