This week, the Bank of Canada held its last policy meeting of 2021 and left official interest rates unchanged, with only minor changes to the language contained in its statement versus the last meeting. Those changes, however, were tilted towards recognizing that upside risk on inflation remains dominant as supply bottlenecks persist. This reinforced the market’s expectation of an earlier and potentially more aggressive hike in interest rates in 2022 compared to the US Federal Reserve.

There are a number of factors that support this expectation, starting with the fact that the Bank ended its quantitative easing (bond buying) program as of October. In contrast, the Fed has only started to taper its program and is not expected to be done until March of next year. Both central banks have indicated that any move higher in interest rates would not begin until quantitative easing had stopped. For Canada, that green flag has already been waved. This is not necessarily a one for one relationship though. While market participants began to price in Fed rate hikes in the second quarter next year, on the assumption that quantitative easing would be over by March; the fact that the Bank has ended bond buying this quarter doesn’t mean we start raising rates in January (the next policy meeting is January 26th).

 

Keep in mind that the Bank was actually pretty aggressive in the expansion of its balance sheet relative to the Fed. As you can see from the chart, Bank of Canada assets exploded by the summer of 2020, in comparison to the start of the year. Quantitative easing might be over, but compared to the US we are still bloated, so to speak.

The other reason given for the possibility of the Bank moving on rates ahead of the Fed is that output gap in Canada is tighter than earlier estimated. What is the output gap? Essentially, it is the difference between actual output of the economy and the potential output of the economy. If an economy is producing below its potential, then we say it is operating with slack. That degree of slack can shrink if growth in the economy accelerates relative to potential, or if potential output growth slows, or potential output contracts. This can happen if there are supply pressures from either capital or labour.

In a speech following Wednesday’s policy statement, the Bank’s Deputy Governor – Toni Gravelle – said that the Bank would provide an updated estimate of the economy’s productive capacity in January. This will take into account information we see today and developments into the New Year. If the Bank doesn’t see improvement in supply, then that capacity could get marked down and if demand remains high (i.e., actual output of the economy continues to grow at a strong pace), then the output gap tightens and the implied upward pressure on inflation remains.

 

Since February 1991, Canada has an inflation control target and was the second country in the world to adopt such a monetary policy mandate, after New Zealand introduced it in 1990. That control target has been maintained at 2% ever since, with regular reviews of the target taking place every five years. The last five-year period ended a couple of months ago, yet there was no mention of whether the mandate would be maintained or if a new targeting regime would be introduced. Speculation was that the Trudeau government wanted to puts its fingerprint on policy by either introducing a dual mandate (maximizing employment and controlling inflation, like the Federal Reserve); or changing the inflation target to an averaged inflation platform (also like the Fed).

There were suggestions on Thursday that there would be no changes to the targeting regime.  Likely, this is a reflection of the fact that the federal government is under so much pressure already from complaints over rising prices; that the last thing one would want to do is implement a shift allowing things to run hotter than they already are. The issue is that if the Bank is going to stick with a disciplined 2% inflation target, and inflation is running almost three percentage points above that target, then the odds of rate hikes happening sooner rise.

For a little perspective, remember what happened back in 2010. Not much more than a year after global stock markets bottomed and economies were recovering from the “great recession”, the Bank of Canada decided to go it alone and start raising interest rates in June of that year. It was also about a year after the Bank had ended its rate cutting program, with the overnight rate falling to 0.25% (yes, today’s rate). The Bank would increase rates a quarter-point in three consecutive meetings, taking it to 1% by the end of the summer that year. Inflation had not even gotten back to 2%, after hitting minus 1% in 2009. In fact, economic activity started to falter after the end of that year and Canada never saw a 4% year-over-year growth rate in GDP again until 2017. The Bank was actually forced to lower rates in 2015.

 

 

Today, growth is again backsliding, but from a distorted pace in the aftermath of the pandemic-induced recession. So, I attribute any eagerness at the Bank to start raising rates before the Fed to inflation fear and not so much the output gap. At 4.7%, consumer price inflation in October was the highest since 2003. And, even though Bank officials continue to state publicly that they believe supply pressures will diminish over 2022 along with inflation; if you have a 2% inflation target it is hard to keep from hitting the brake pedal. The question is whether the Bank risks being first out of the starting gate, only to finish last when the checkered flag is waved.

For Canadian households, a few rate hikes shouldn’t derail things, although housing markets are so stretched, one has to be careful not to be too dismissive of the net impact of higher borrowing costs. According to the median forecast of economists, the first rate hike isn’t anticipated until after June. Surveys haven’t been updated since this week’s meeting, so I would probably peg the median for a first hike either in April or June. The median expectation for the end of 2022 was an overnight rate of 1%, but that is probably more like 1.25%. In other words, economists are marking up there forecasts to show at least a 1% rise in rates by this time next year, or perhaps more.

 

 

If economic activity remains buoyant and inflation falls, but not back to 2%, it is reasonable to expect the Bank to continue tightening into 2023. This is when it gets interesting. At the time of the tech bubble burst in 2000, the overnight rate had peaked at 5.75%. Prior to the financial crisis, it topped out at 4.5% and, in 2018, we got to a stratospheric 1.75%. People forget that activity wasn’t exactly amazing in 2019 before the pandemic. So, do we break this pattern of lower cyclical highs for short-term rates? Maybe, go above 2%?

This isn’t an exercise in technical analysis. Rather, it’s a reflection of a trend towards larger and larger debt levels in the economy, which creates a stronger sensitivity to interest rates. In other words, unless the debt trend is broken, it takes smaller increases in rates and lower absolute levels to bring about slower growth. The other angle to that is that our margin of error in terms of overshooting on rates is getting slimmer. I’m not sure if Bank officials are reflecting on 2010, but I’m absolutely sure they are cognizant of where the next peak in interest rates will be and it may not be 2%. It’s one thing to be first out in front on the green flag, but the Bank of Canada has to be careful not to be last across the finish line on the checkered flag.