Bank of Canada not ready to hit the brakes on rate hikes yet, economists say

Economists don’t believe the Bank of Canada is ready to hit the brakes on its interest rate-hiking cycle just yet, even as signs grow that inflation is easing and the economy is softening.

Canada’s central bank is expected to announce its eighth consecutive rate increase on Wednesday, with most commercial banks forecasting a raise of a quarter-percentage point. That would bring the central bank’s key interest rate to 4.5 per cent, the highest it’s been since 2007.

Although headline inflation slowed noticeably last month, Royce Mendes, Desjardins managing director and head of macro strategy, said the labour market is still hot and underlying inflation pressures are still “sticky.”

“I think (the bank will) use all of that to justify the further rate increase,” Mendes said.

Last month, the unemployment rate fell to five per cent, slightly above the all-time low of 4.9 per cent.

After raising rates again in December, the Bank of Canada signalled it was open to pressing pause on its aggressive rate-hiking cycle, depending on upcoming economic data releases.

The Bank of Canada is likely encouraged that headline inflation is slowing. After peaking at 8.1 per cent in the summer, the annual inflation rate has cooled to 6.3 per cent in December.

However, Mendes noted that core measures of inflation, excluding more volatile items such as food and gas, edged down only by a bit last month.

For months, market-watchers have been trying to guess when the central bank would be ready to stop raising rates, with some expressing optimism that December’s rate hike would be the last. However, this time, most forecasters seem to agree on a January hike, saying an increase next week would be the last increase of the cycle.

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Mendes said although he also expects this to be the last raise for now, Canadians shouldn’t be too confident that interest rates won’t rise further.

“The Bank of Canada needs to make sure that it has done enough to put inflation back on a path towards the two per cent target. And that’s not clear just yet,” he said.

TD director of economics James Orlando said even if it intends to stop raising rates, the Bank of Canada can’t appear to be backing off too much in its announcement next week.

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Orlando expects the Bank of Canada to say it doesn’t foresee the need for more rate hikes, but that it will keep monitoring how economic conditions evolve. That way, the door is open for further rate hikes if necessary, he said.

“Obviously, if things get out of hand … then they might have to raise rates again,” Orlando said.

Since March, the Bank of Canada has embarked on one of the fastest rate-hiking cycles in its history. After slashing interest rates to near zero during the pandemic to stimulate a plummeting economy, in 2022 it hiked rates rapidly to clamp down on skyrocketing prices.

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The rate hikes have already slowed the housing market considerably and are expected to affect the economy more broadly with time. Businesses and consumers facing higher borrowing costs will pull back on spending, thereby reducing demand in the economy and easing upward pressures on prices.

Yet up until now, economists say much of the decline in inflation has been caused by things outside of the Bank of Canada’s control, such as lower energy prices.

That means the full brunt of interest rate hikes has yet to be felt. Mendes said the Bank of Canada is trying to balance the risks of raising rates by too much or too little.

“It’s a very difficult balancing act,” he said.

The Bank of Canada will also release its quarterly monetary policy report on Wednesday, which will provide updated forecasts for economic growth and inflation.

As the Canadian economy reacts to higher interest rates, many economists are saying Canada will enter a mild recession this year.

Although there’s no evidence yet of a recession, there are signs that high interest rates and inflation are weighing on firms and consumers.

This week, the Bank of Canada released its business outlook and consumer expectations surveys, which showed firms are losing confidence and Canadians are cutting spending to compensate for ballooning bills on necessities.

At the same time, inflation expectations were still relatively elevated in the surveys.

“That suggests, in and of itself, that the bank might want to err on the side of tightening a little bit more in the near term,” Mendes said.