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Bank of Canada hiked interest rates to ‘forcefully’ tame inflation. Will it work?

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Experts say the Bank of Canada’s efforts to tackle inflation with oversized interest rate hikes will take time to bring price growth back to normal levels as the central bank races to catch up with an economy that’s bouncing back stronger than first anticipated.

The Bank of Canada raised the target for its overnight rate to one per cent on Wednesday, delivering a rare 50-basis-point hike to the benchmark interest rate.

Governor Tiff Macklem told reporters Wednesday morning that the oversized step was necessary to rein in inflation and economic growth that had surpassed the central bank’s original forecasts.

“With inflation well above target, with the economy moving in excess demand, there is a need to normalize monetary policy relatively quickly,” he said.

Read more: Bank of Canada due for ‘oversized’ 50-basis-point interest rate hike, says economist

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While the Bank of Canada’s outlook in January pegged the annual rate of inflation at an average of five per cent through the first half of the year, it now expects inflation levels of six per cent across the first six months of 2022.

The key thing the bank didn’t anticipate when it held its rate at historic lows of 0.25 per cent in January was the war in Ukraine, which has pushed inflation higher through elevated prices on commodities such as gasoline and food.

But it also didn’t expect the economy to bounce back quite as quickly as it has. A robust jobs market — unemployment is now below pre-pandemic levels — is driving demand and consumer spending at a feverish pace, Macklem said.

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Why a 50-basis-point hike?

The larger step marks a departure from the bank’s usual approach to rate hikes, which aim to take the steam out of the economy by raising the cost of borrowing for Canadians. The last time it raised rates by half a percentage point was May 2000.

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The bank has usually told market watchers that it’s better to do rate hikes earlier and at a “slower and measured pace” that allows it to observe the impact of its rate hikes on the economy and Canadian households, TD Bank chief economist Beata Caranci told Global News in an interview Wednesday.

While economists had widely expected the increase of half a percentage point on Wednesday, hiking beyond the standard 25-basis-point step shows that the Bank of Canada is feeling the heat and had to reassert its credibility, Caranci said.

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“Had they not done 50 basis points today, especially with the markets having priced it in and they only went, say, 25 basis points, that would have hurt their credibility as an inflation-fighting central bank mandate,” she said.

“There was even some speculation they could have gone a little bit higher than that, but that could have done the opposite and unnerved the markets as being almost panicked. So they delivered on market expectations, and we think they’ll likely do that again.”

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Read more: 60% of Canadians worry about feeding their families amid inflation, Ipsos poll shows

Caranci, as well as other Big Bank economists such as BMO’s Doug Porter, expects another 50-basis-point increase from the central bank in June. Royal Bank of Canada has a 25-basis-point increase on the cards for the next announcement but did not rule out a half percentage point hike.

The Bank of Canada signalled that it believes the neutral range for interest rates — the point at which they’re neither negatively or positively affecting economic growth — is somewhere between two and three per cent, and that there will be more hikes coming to get closer to that point.

The bank could “pause” before that benchmark to see the impact on Canadians, Macklem said, as current high levels of debt across the population can make households more vulnerable to sudden hikes.

“But equally, we might have more work to do,” he added.

“The economy has considerable momentum, labour markets are tight. If that momentum continues, we may need to take rates modestly above neutral for a period to restore balance between demand and supply and bring inflation back to target.”

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When will inflation start to drop?

The Bank of Canada’s revised outlook still sees inflation starting to ease midway through 2022 but still remaining above the high end of its one-to-three per cent threshold. By mid-2023 inflation rates could drop to 2.5 per cent and hit the two per cent sweet spot in 2024.

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Josh Nye, senior economist with RBC, told Global News on Wednesday it can take more than a year before the “full effect” of rising interest rates pulls down inflation.

Some areas of the economy, such as real estate, feel the effects of higher borrowing costs more immediately. Rising mortgage rates, in combination with federal and provincial policy changes, have already started to have “some impact” on the housing market, he said.

He cited rising prices of shelter and durable goods as a couple of areas of the economy that will start to ease even before the end of 2022 in response to interest rate hikes.

Read more: Bank of Canada interest rate hike — How it connects to inflation, job market

Other causes of inflation are well out of reach of the Bank of Canada’s interest rates, Nye said.

“Some of these forces that are driving inflation higher right now, particularly food and energy prices, those are global factors, they’re a bit beyond the Bank of Canada’s control and higher interest rates aren’t going to do much to rein in those sorts of inflation,” he says.

What role do expectations play in inflation?

But even if higher interest rates won’t have a material impact on all aspects of inflation, the central bank’s primary monetary policy tool can still have a meaningful impact on expectations, which, in a way, is an equally important input into inflation.

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Macklem reiterated multiple times during Wednesday’s press conference the importance of “anchoring” inflation expectations for Canadians.

Recent consumer and business surveys from the Bank of Canada have shown that while short-term inflation expectations are slightly elevated — “unmoored” from the bank’s two per cent target — long-term expectations have held steady through current price spikes.

Read more: Ongoing supply issues expected to drive prices higher, Bank of Canada survey shows

Nye explained the possible spiral of inflation expectations this way: If Canadians adopt an attitude that prices will just continue to rise, they will in turn demand more in compensation, resulting in higher costs for businesses, who then pass prices on to consumers.

“It sort of becomes this self-fulfilling cycle of higher inflation expectations being fulfilled with higher inflation,” he says.

“The fact that we’re seeing such high rates of inflation and talking about it constantly, has the potential to seep into the consumer psyche and push those longer-term inflation expectations higher.”

For the Bank of Canada, then, a hike of 50 basis points is as much a message to Canadians as it is a policy tool to rein in the economy.

“We are prepared to move as forcefully as needed to get inflation back to target. We took an important step this morning. It’s clear we have more work to do,” Macklem said.

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