There’s a strong argument to be made that the Bank of Canada has raised its rates too high.
That’s according to CIBC deputy chief economist Ben Tal, who says the job of the Bank is to now “manage the size of the overshooting.”
The Bank of Canada has now raised its key lending rate by a whopping 475 basis points, or 4.75 percentage points, since last March. That marks the fastest pace of increases in Canadian history.
In a recent research note, Tal says that the Bank has chosen to err on the side of too many hikes rather than too few for one simple reason: its bias towards fighting inflation.
He goes on to explain that the Bank of Canada is facing two choices, one being ongoing high inflation if interest rates don’t quell excess demand in the economy, or a recession if rates go too high and end up reversing economic growth.
“The Bank will take a recession any day,” Tal notes, since central banks have many tools and much experience in dealing with recessions. Out-of-control inflation expectations, on the other hand, “are a central banker’s worst nightmare.”
At this point in the rate-hike cycle, Tal argues that for every positive, or “bullish,” economic indicator suggesting economic strength, there is another that is equally negative, or “bearish.”
“But given the Bank’s bias, more weight is given to strong indicators,” he writes.
BoC “bullish” despite disinflationary signs
One such example is the Bank’s recently updated growth domestic product (GDP) forecasts. In its latest Monetary Policy Report, it said GDP is expected to grow 1.8% in 2023 on an annualized basis (up from a previous forecast of 1.4%).
However, Tal suggests the revised forecast is “strategic positioning,” and will
“limit the [Bank’s] need to react to any strong indicator.”
Similarly, the Bank’s revised forecasts for CPI inflation returning to its target of 2% by the middle of 2025 “is simply buying time with limited risk of increased long-term inflation expectations.”
“That is a good move,” Tal suggests. “Buying time will allow the Bank to be less reactive to current/near-term strong numbers while allowing time for some important disinflationary forces to unfold.”
Those disinflationary forces include improvements in supply chain conditions, which is having the effect of reducing retailers’ gross margins, which Tal calls “an underrated disinflationary force on both sides of the border.”
He also points out that the labour market may not be as tight as it seems due to labour supply being underestimated by a “significant undercounting” of non-permanent residents in Statistics Canada’s employment data.
Will the Bank hike again in September?
The big question remains whether we’ve seen peak interest rates from the Bank of Canada, or whether an additional increase could be on the horizon.
Markets continue to overwhelmingly expect one more quarter-point rate hike at the Bank’s next policy meeting on September 6, with 80% odds currently.
Tal notes that the Bank may continue to go deeper into “overshooting” territory, but adds the impact of its past rate hikes will soon be felt more broadly.
“The Bank of Canada might hike again in September,” he writes, “but soon enough the current disinflationary forces will be too noticeable to ignore, even for a biased bank.”
