Bank of Canada Warns More to Come After Another 75 Bps Rate Hike

The Bank of Canada (BOC) maintained its aggressive stance towards inflation as it raised interest rates by 75 basis points (bps). This is the fourth consecutive outsized hike, bringing its target overnight rate to 3.25%. The benchmark rate has now increased 300 bps this year alone.

In its statement, the central bank noted the global and Canadian economies are progressing broadly in line with its July projection. Lingering COVID-19 outbreaks, ongoing supply chain issues, and the war in Ukraine continue to put upward pressure on prices. 

Why is the BOC continuing to increase rates?

Canada had disinflation - a decline in the rate at which prices rise - for the first time in a year last month as the Consumer Price Index increased 7.6% year-over-year, down from 8.1% in June. 

However, as we covered in a previous market update, falling gasoline prices were the main factor in this lower CPI. Inflation excluding gasoline actually increased 6.6% year-over-year, up from 6.5% in June. 

What is causing inflation to rise?

There are a myriad of causes for inflation but let’s focus on one: consumer demand. What we are seeing now is a classic example of demand-pull inflation. When businesses struggle to keep up with strong consumer demand, the cost of goods and services goes up. If this persists long enough it pushes inflation higher and higher. 

Supply issues are not improving and although Canada’s GDP grew less than expected, it was still up 3.3% in the last quarter. On top of this, domestic demand remains high. 

So what would it take to get back to a sustained fall in prices, known as deflation? Weakening demand would certainly help alleviate some of the pressure? The BOC can influence this somewhat with the main weapon in its arsenal - interest rates.

Raising interest rates theoretically reduces consumption by increasing the cost of credit. Higher rates also incentivizes Canadians to save their money rather than spend it, which in turn reduces demand. However, this is a tightrope walk. Raise rates too much and it could stifle the economy and lead to a recession..

What is the outlook for inflation?

According to the central bank, surveys suggest the cost of living is expected to increase further in the short term. If this continues, there is a risk inflation will become entrenched and high prices become the new normal.

One indicator that inflation will not decrease any time soon is employment levels. There tends to be an inverse relationship between inflation and unemployment. When unemployment is low, inflation tends to be high and vice-versa. As of July, unemployment remains low at 4.9%. Unless it increases, and the economy keeps growing, there will continue to be higher demand and pressure on prices.

What happens next?

The BOC’s Governing Council, which decides interest rates, is sending a clear message that its policy of quantitative tightening will continue. It says it “remains resolute” in its commitment to price stability and it will continue to take action.

Further rate hikes are almost a certainty. After Market Close on Wednesday, the market was pricing in a 72% probability of a 50 bps hike when the Bank of Canada meets again on October 26. 

Our advice

The guidance we give our clients remains the same: invest in blue chip stocks and take advantage of the rising interest rate environment with some short-term fixed income securities such bonds and Guaranteed Investment Certificates.

As always, if you have any questions about today’s Market Update, you can call us at 604-643-0101 or email cashgroup@cgf.com