Bank of Canada increases policy rate to 4.25%

The Bank of Canada raised its policy rate by 50 basis points to 4.25% on Wednesday, the seventh consecutive increase since March. In our estimation, the Bank of Canada is nearing the end of a rate hike cycle that we expect will peak at 4.75%. The Federal Reserve, by contrast, will almost certainly lift its policy rate above 5%. While the Canadian economy has proven resilient amid elevated inflation and rate increases over the past two years, the policy statement noted that there is growing evidence that tighter monetary policy is restraining demand. That underscores our core forecast that we are nearing a strategic pause in the Bank of Canada’s efforts to restore price stability. We think that the Bank of Canada, like the Federal Reserve, will adopt a similar lift-and-hold framework in which it engages in a strategic pause early next year to ascertain the impact of past rate hikes. The Bank of Canada noted it is considering further hikes to curb inflation, which should come as little surprise. Even though economic headwinds will most likely gather pace through the middle of next year, the central bank retained its tightening bias as it tries to reduce demand, which suggests a rising probability of recession next year. A slower pace of rate hikes makes sense at this point given the risks of overtightening and triggering a recession. The Canadian economy is more sensitive to financial conditions than the U.S. economy. Our RSM Canada Financial Conditions Index stands at roughly two standard deviations below neutral, which is a substantial drag on overall economic conditions. Should the Bank of Canada increase rates above 4.75%, further into restrictive terrain, then it is likely that the Canadian economy will tip into recession by the middle of next year.