Since the Russia-Ukraine conflict began to intensify, market participants have been scaling back the degree to which they expected central banks to raise rates this year. That doesn’t mean rate hikes were taken off the table, as we saw this morning with the Bank of Canada. Even though the Bank cited increased uncertainties around the impact of Eastern European tensions, it followed through with what we thought it would do – increase the overnight rate target by a quarter-point to 0.5%.

 

 As much as there will be fallout on Canadian growth from the crisis, not to mention the disruptions from the Omicron wave in January and then protest blockades, the Bank saw this risk as lower than that posed by the inflation story. Indeed, in the Bank’s accompanying statement, it said that inflation is running hotter than what they had projected at the January meeting.

 

Assuming the Federal Reserve decides to raise rates at its policy meeting this month, the Bank can be seen as just following suit; however, what we are seeing is not just a North American synchronization. Back in 2010, as global economies were still reeling from the effects of the Financial Crisis, the Bank came out in front of the Fed and lifted rates in June. This was the first of three and, while the decision was a mistake in hindsight, it was premised on similar arguments made today.

 

 

Not only is Canadian inflation well above the Bank’s official target of 2%, but the economy finished 2021 on a strong note. December activity may have been flat, but real GDP growth came in higher than forecast at 6.7% (on an annualized basis).  This followed a healthy 5.4% expansion in the third quarter and more than made up for the temporary setback seen in the summer.  As I mentioned, we don’t expect this pace to be maintained in the first half, but as long as the economy continues to grow at close to potential, the Bank believes there is a reason to adjust rates to combat inflation.

 

The notion of “potential” is important for a central bank because if an economy grows faster than potential then the gap between potential output and actual output shrinks. If it is positive, then the argument for rate hikes is strong but, even if the gap is still negative but closing, a central bank can rationalize the start of a tightening process. As you can see from the above chart, that is the case today.  In fact, the Bank of Canada’s estimate of the output gap as of the end of 2021 is very close to where it was when it started raising rates in 2010. For that reason, this morning’s decision is not a surprise.

 

 

The one thing we will say, however, is that the timing of future rate moves is less clear because of Ukraine. Ally and I originally called for 3-4 consecutive hikes before a pause (same forecast as for the Fed), but this may turn into a more moderate trajectory.  On the other hand, if supply disruptions from the conflict and the escalation in commodity prices filter through into a more prolonged inflationary environment, absolute monetary tightening could turn out to be heavier.