In an effort to target inflation that is at its highest level in decades, the Bank of Canada on Wednesday increased its policy interest rate by 50 basis points, to 1%, and said it would begin to reduce its balance sheet, known as quantitative tightening.
The move was widely expected following the bank’s comment last month that it would act forcefully to control inflation, particularly over the long run, in an effort to head off the possibility of inflation becoming entrenched for many years.
The central bank has sound reasons to accelerate the pace of rate hikes:
- Global events are adding pressure. First, global events, including the war in Ukraine and COVID-19 outbreaks in China that led to lockdowns in key trade and manufacturing hubs, add pressure to the supply chains and drive the inflation outlook higher. In particular, the war in Ukraine alone added 0.7% to the Bank of Canada’s inflation outlook.
- The Canadian economy is overheated. Consumer demand remains strong despite price increases, and the unemployment rate is the lowest in nearly half a century. Increasing interest rates would make borrowing more expensive, which in turn will cool the economy, including the housing market.
The Bank of Canada’s balance sheet ballooned the most among all major central banks, increasing almost five-fold since the pandemic began, compared with a 114% increase for the Federal Reserve. Quantitative tightening is in order, and the bank said it would stop replacing maturing securities on its balance sheet later this month. An outright selling off of assets in the near future would not be surprising.
Nonetheless, monetary policies take time to work through the market, so one should not expect magic. Inflation will remain around 6% in the coming months before the effects of rising interest rates are felt.
Amid the uncertainty, the Canadian economy is well positioned to grow this year given its competitive advantages in the commodities and energy sectors. For this reason, a rate hike is a given in the next announcement in June, and a 50 basis-point increase would not be out of the question.
