The Bank of Canada and Federal Reserve each have eight policy meetings during the year, however, it’s pretty rare for these meetings to take place within a day of each other. That was the case this week and the market assumptions going into this week was that the Fed would only signal rate hikes to start in March, while the BoC might actually begin its tightening trek now. That wouldn’t be the first time the BoC pushed rates higher ahead of the US central bank, but this time around it did the same thing and kept its overnight target rate unchanged at 0.25%. The notion by some economists that the Bank would lift rates this week were driven by a couple of factors.

 

First, the BoC (unlike the Fed) has an official inflation target and, in December, it kept it at 2%. I say “it”, but effectively this mandate comes from the federal government and then jointly announced. If a central bank has an official target, then there is a lot of credibility on the line when faced with inflation outcomes that are significantly different from the target. This has definitely been the case for the BoC, with consumer price inflation reaching 4.8% in December – the highest since September 1991.

 

Ironically, it was February 1991 when the Mulroney government and BoC implemented the 2% inflation targeting regime, following the likes of New Zealand, in response to two decades of excessively high inflation (and interest rates). The last time Canada had seen a 2% inflation rate was back in May 1971 and up until the month before the announcement, the average inflation rate in Canada was 7.1%. The policy worked. Even with the rising inflation during 2021, the average pace since the targeting regime was put in place in 1991 was 1.9% as of December.

 

The inflation target has been reviewed every five years since 1991 and this past December was the latest review (actually arriving a little later than scheduled). The only nuance was that the government gave the BoC latitude to let inflation run a little hotter than 2% in order to support economic (and more balanced) growth. That surprised some economists, though it again followed the shift by the Fed recently to move from a 2% implied target to an average targeting approach. The BoC Governor did come out and push back a little to ensure that the Bank would not wander too far away from its mandate of price stability. That reinforced some calls for a rate hike this week.

 

The other factor is that Canada’s labour market has done so much better than the US since the pandemic and all employment losses during this episode have been recovered. Now, that doesn’t mean that the recovery has been even across all segments; but, from a macro view, Canada has reached full-employment ahead of the US. For some economists, this means that monetary policy should be adjusted ahead of the Fed. Perhaps, though the biggest threat to inflation from full-employment is an acceleration in wage inflation and Canada does not appear to be at as much risk.

 

 

Canadian and US average hourly earnings inflation did spike to above 10% and 8%, respectively, back in 2020 (distorted by government programs), but pulled back sharply in early 2021. What we have seen in both countries since the summer has been a re-acceleration in wage growth, not because of programs but from labour market tightness. That said, Canadian average hourly wages are still just running at a 2.7% pace, compared to a 4.7% rate in the US.

 

In my opinion, there is nothing substantively different in the macro environments for both Canada and the US that would argue for one central bank moving on rates before the other. Nor is there anything that suggests the BoC or Fed should delay rate hikes beyond March. As I discussed last week, the market has done a great job in adding bricks to the wall of worry around excessive policy tightening and we saw that again this week. From pricing in a couple of hikes for 2022 back in December, participants are thinking 5 or more. Possible, but we haven’t even had the first one yet.

 

At a pace of a quarter point per meeting, both Canada and the US would get overnight rates to 1.25% by July. As you can see from the chart, this would be a faster steeper trend of rate adjustments than the last cycle. That cycle was disjointed between the two countries. The BoC went too early in 2010 and had to back-peddle into 2015. The Fed waited until December 2015 before raising rates, but took a long pause before the next one in June 2016. I tend to look at the Fed cycle as not starting until that month but, even still, it was a year before we had added a percent. The BoC waiting until July 2017 before starting to lift rates and also took a year to add a full percent.

 

 

Bottom line, if we are going to raise rates by 1% in five months I really don’t see how that is an example of either central bank being behind the eight ball on inflation. There have been indications of some moderation in economic demand and that doesn’t even factor in the negative impact of higher energy prices on consumer demand for discretionary items. Could we see an overshooting by the Bank of Canada on rates? Absolutely, but we are several rate hikes away from that becoming a major risk for markets. That said, for those individuals and families that have debt, especially floating-rate credit, this is a good time to do some stress testing of the budget.