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BoC Enters “Tricky” Stage as Inflation May Rise Again

August 8, 2023 8 min 11 sec
Avery Shenfeld
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Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Avery Shenfeld, chief economist at CIBC.

We at CIBC were always in the minority camp in that we were not predicting a recession would be necessary or inevitable to get inflation down to the 2% target.

And the progress we’ve made to date, in fact, is good evidence of the thesis that we laid out more than a year ago, which was that a lot of the inflation that countries like Canada, the U.S. and Europe were experiencing wasn’t necessarily tied to an overheated demand side to the economy. It was tied to the shocks to food and energy prices from the war in Ukraine, the disruptions to production in the good side of the global economy from shutdowns associated with the Covid-19 pandemic and really, a surge in goods consumption during the pandemic as people moved away from services towards doing things at home and purchasing goods. And our view was that a lot of that inflation could melt away on its own once some of those disruptions were behind us.

That’s in fact what we’ve seen. Now, there is still a residue of excess inflation because the economy is slightly overheated, and we still need a cooling ahead. But our view is that in Canada as well as in the U.S., a recession isn’t necessary to get inflation down to 2%. We need a cooling off of economic growth, basically a stall in the economy for a few quarters, but not necessarily an outright recession.

The tricky part for the central bank in Canada, the Bank of Canada, is that inflation is likely to go a bit higher again before it goes lower. That’s largely because we’ve seen the biggest benefits from the year-on-year decline in gasoline prices. And so that’s going to drop out as a big downward pull on the inflation rate, leaving the inflation rate drifting a bit higher.

So we’ll need to see a bit of a stall in economic growth for a couple of quarters, at least a bit of a rise in the unemployment rate to cool wage inflation and take down purchasing power in the economy. And the tough task for the Bank of Canada is to gauge just how many rate hikes are necessary or what level of interest rate is necessary to get just that cooling as opposed to a big recession that we simply don’t need.

Our judgment is that the Bank of Canada should have enough doubts at this point that it shouldn’t be raising interest rates. That again, it might want to show some patience and let the economic data roll in for a couple of quarters to give it more insights as to whether or not they’re seeing enough of a slowdown in the demand side of the economy, enough of a slowing in things like housing, for example, to bring inflation back to 2%. The Bank of Canada doesn’t seem quite as patient as perhaps we would like. Our view was that even the last rate hike might have been unnecessary. So we may well face a rate hike another quarter point in September, but we’re pretty confident that by the end of the year, as we get close to December, the Bank of Canada will see enough signs of a slowing that if we do have one more quarter point hike in September, that that will be the last rate hike we see for this cycle.

What the Bank of Canada is going to look at when we get to its September decision is what’s really happening in the labour market. They know that inflation might drift up a bit from here to September. That’s not really going to be their focus. Their focus is on whether hiring is slowing enough to bring wage inflation down, to slow labour income growth so we don’t have as much spending in the economy in effect, and they’re going to be watching, therefore, the series of monthly employment reports that we get now till to the Fall.

If we receive some strength there, if the unemployment rate instead of drifting higher moves lower again, then I think that would push them into that September rate hike. One thing we have to remember is that when we’re getting down to the last few rate hikes, there’s an element of art as well as science. Because the economy doesn’t respond exactly the same way to interest rate hikes from one business cycle to the next, no one’s models based on past responses are going to be that accurate. So we can forgive the Bank of Canada if they ended up hiking one or two times too many. That won’t be a fatal error.

The big danger for the Canadian economy is that the rate hikes we’re delivering now are going to continue to have significant impacts on the Canadian economy into 2024 and indeed into 2025. Many Canadians have yet to renew mortgages at higher rates, and in particular, those that have mortgage renewals coming out in the next couple of years will include people who took out mortgages, for example, in 2020 when rates were at rock bottom levels. And so those will be very large increases in their monthly payments. So the biggest danger here isn’t so much whether the Bank of Canada raises rates a quarter point or a half a point too much. It’s almost whether or not they judge correctly the time to start easing up on interest rates so that we’re not further slowing the Canadian economy in 2024 and 2025 when inflation might be back at the 2% target, and we simply don’t need that additional breaking force on the economy.

Canada’s been a bit blessed in the last several months. We have one of the biggest declines in inflation relative to other countries. If you look at common measures of underlying inflation, the improvement in Canada’s been a little better than in many other countries, particularly some of the countries in Europe. So we’ve had more relief in our inflation rate from things like the fall in gasoline prices and other global prices than some other countries, which suggests that the job of getting inflation down to 2% might not create as much economic damage here as might be necessary, for example, in the U.K. where inflation has been a bit more sticky.

As well, in Canada, a lot of the inflation we’re measuring is the inflation in mortgage costs as Canadians renew at higher interest rates, and once the Bank of Canada’s done raising rates, and in particular when they start easing rates, that component of inflation will drop off.

Not all countries measure the CPI the same way, so not all countries will get that same benefit in inflation when we look out to 2024 or 2025.

The Canadian economy has managed to continue to grow, albeit somewhat slowly in the wake of all the interest rate hikes we’ve already had. But I think it’s important to recognize that there are some things ahead that are going to see a slowing. Housing starts have generally been easing off. That hasn’t really shown up yet in layoffs in the construction sector because workers are busy completing all the houses and condos that were started six months or a year ago. So I think the slowing from that still lies ahead.

And we also have to recognize that globally, central banks around the world are raising interest rates, aiming at slowing their economic growth. So we might expect to see some deceleration in the growth that we’ve been enjoying in our export sector.

Even though we’re not expecting a full-blown recession, there’s certainly parts of the economy that are going to see outright declines: the parts of the economy that are most sensitive to the increases in interest rates, both at home and in our trading partners.