Recession fears won’t faze Bank of Canada, economists say. Why that may be a good thing

Governor Tiff Macklem defended a surprise jump in the Bank of Canada’s benchmark interest rate on Wednesday with the argument that “front-loaded” rate hikes are more likely to skirt a recession.

But he also made it clear that the central bank is willing to go as far as it needs to “choke off the excess” demand from Canada’s economy and bring prices back to normal levels.

Even if that ends up dipping Canada into a mild recession, it would probably be worth the short-term pain to rout rampant inflation, according to economists who spoke to Global News.

The Bank of Canada’s move to hike interest rates by 100 basis points to a total of 2.5 per cent on Wednesday shocked many economists and market watchers, the majority of whom baked in an increase of three-quarters of a percentage point.

Macklem acknowledged when speaking to reporters Wednesday that there might be some shocks to breaking from the consensus estimates, calling the increase “very unusual,” but he said so too are the economic conditions facing the central bank’s policymakers.

Inflation, which clocked in at 7.7 per cent in May, is trending higher than first forecast and is broadening. Domestic pressures are now contributing to the price growth that was mostly driven by global factors such as the war in Ukraine and supply chain kinks.

Canada’s economy is running too hot, or in economic parlance, it’s in “excess demand.”

A tight labour market with wages finally ticking up is likely to only fuel inflation, Macklem said, which the central bank now expects to average out at eight per cent for the third quarter of the year.

1:38 Bank of Canada projects ‘soft landing’ approach to addressing inflation

To get inflation back down to the bank’s one-to-three per cent target range, Canada’s economy needs to contract, he argued. Doing so would give lagging supply time to catch up to the fervent demand that’s driving up prices.

With a rate hike of 100 basis points, Macklem said his message to Canadians is that high inflation is “not here to stay,” but he cautioned that the path back to “predictability” will be bumpy.

“It is going to take some time to get inflation all the way back down to our two-per-cent target,” he said.

“This is not going to be without some pain.”

Calls for a possible recession in the next year have begun to simmer in recent months.

Macklem conceded to reporters Wednesday that the path to a “soft landing” — an economic contraction that skirts a formal recession — has “narrowed” and that “stronger action” is required to get inflation back under control.

Bank of Canada policymakers signalled Wednesday that interest rates would have to continue to rise in the months to come.

RBC senior economist Josh Nye told Global News this week that the bank will likely keep hiking rates past July.

“I think they are going to remain on the side of acting more forcefully and getting inflation under control, even if that means greater risk of a slowdown,” he said.

2:17 Bank of Canada governor on why key interest rate announcement came relatively suddenly

Nye projected after Wednesday’s hike that rates would continue to rise to 3.25 per cent by October.
That would put the bank’s key interest rate above the so-called neutral range of one-to-three per cent and into restrictive territory — the point at which the Bank of Canada believes its policy rate would actively stifle economic growth.

Royal Bank of Canada was the first big bank in the country to predict an economic contraction on the horizon with a report last week that called for a “moderate” but “short-lived” recession in 2023.

RSM Canada economist Tu Nguyen said in a statement Wednesday that she agreed the Bank of Canada will have to induce a “slowdown” to see price stability return, but an “economy-wide recession is still unlikely in 2022.”

She predicted that the housing sector, which has already seen a slow down due to its vulnerability to interest rates, will see a decline but other indicators such as business activity and the labour market point to a “still rather healthy economy” through the rest of the year.

Derek Holt, vice-president at Scotiabank Capital Markets Economics, told Global News on Tuesday that while the bank doesn’t currently have a recession in it forecast, he doesn’t think rumblings of a contraction would stop the Bank of Canada on its current rate hike cycle.

“I don’t think that would faze the Bank of Canada. I think they probably view it as a necessary condition to cool down the economy in order to stand a chance of cooling down inflationary pressures,” he said in an interview on Tuesday.

Craig Alexander, chief economist at Deloitte Canada, told Global News this week that a recession might not be the worst outcome from the central bank’s perspective.

“I don’t think the Bank of Canada wants to cause a recession, but I think that the Bank of Canada is prepared for one if it’s required to address inflation,” he said Tuesday, echoing Holt.

Alexander added that Canadians should not be “unduly fearful” of a recession, which, if it comes to pass, would only likely last two or three quarters.

A recession would be a quick way to bring inflation back down, he argued, as consumers drastically reduce their spending and businesses cut prices to move unsold inventory.

Alexander said he expects the Bank of Canada to pause its rate hike cycle sometime in the fall and assess the impact of its increases by that point and the status of global inflationary pressures.

“It’s going to be very difficult because it’s more art than science, right? They don’t know exactly what the right interest rate level is that’s going to cool down the economy but not cause a recession,” he said.

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Both Nye and Holt agreed with Alexander that a recession is not the worst outcome for the Bank of Canada.

Nye said getting inflation under control — recession or no — should be the “number-one priority” for the central bank.

“I think the worst risk at this point in time is to allow inflation to get further out of control,” Holt added.

“That’s something that could be more damaging, if allowed to fester over time, than higher interest rates, because it means instead of paying more on your mortgage interest payments and consumer debt payments, you’re paying more on everything else that you consume, which dominates the household budget.”

Macklem told reporters Wednesday that Canadians could be at risk of economic pain if the country falls into the “wage-price spiral.”

In this instance, Canadians would see inflation continue to surge as workers bid up their wages to keep pace with price growth, only to find businesses pass higher prices on to consumers to offset the increased costs.

“If that happens, it’s going to take a much sharper slowing of the economy to get inflation back to our target,” Macklem said.

The way to cut the wage-price spiral off at the pass is to keep inflation expectations under control — and Macklem said Wednesday that the central bank is willing to make aggressive, even surprising hikes to tame inflation in the long run.

“By front-loading our response, we are really doing everything we can to avoid that risk materializing,” he said.

The Bank of Canada’s next interest rate decision will be announced on Sept. 7.

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