The Bank of Canada kept its policy rate at 0.25% at its December meeting on Wednesday as it prepares the public and market participants for the normalization of monetary policy and the first increase in interest rates next year.
The central bank’s policy rate decision and forecast, on the back of a strong run of economic data, implies that the bank is moving toward its first rate hike in April with a market that is now pricing in five rate hikes next year.
The major change to the central bank’s statement was the elevation of inflation risks to the outlook, which should underscore the market expectation of the five rate hikes and our estimate that the central bank will raise rates in April with the chance of an earlier move.
In particular, the bank’s removal of the word “temporary” from the pricing paragraph denotes a modest shift in emphasis toward maintaining well-anchored inflation expectations and should further prepare market participants for the rate hikes.
While growing market expectations of a near-term rate increase may be tempered by the central bank’s noting that its forward guidance will be maintained and the policy rate not increased until the recovery is complete, accelerating prices and the recovery in the labor market could facilitate a change in that outlook.
In fact, Canada’s fixed-income markets had already begun pricing in the risk of growing inflation and the central bank’s eventual response. And with the moderation of support from equity and commodity markets, the degree of accommodation in the financial markets dropped below normal levels for the first time since July 2020.
The delta and omicron variants present risks to the Bank of Canada’s growth and policy forecast early next year as it carefully moves toward the normalization of rates. Still, diminished economic slack and a tighter labor market, in addition to inflation approaching 5%, will underscore that move toward normalization as central bankers place more emphasis on price stability.
The Bank of Canada was careful to state that the economy continues to require considerable monetary policy support and noted that the flooding in Western Canada could impinge on growth in the near term. Supply chain disruptions, the bank added, continue to affect growth prospects despite the strong momentum in the economic data for the current quarter.
Beyond the public health risks to the outlook, it appears that with inflation running at two-decade highs and likely to increase in the near term, the risk to the outlook is that the Bank of Canada could lift rates as early as its January meeting. While we think that is a low probability given the current state of growth, employment and inflation, one cannot rule it out.
