Bank of Canada: Hike More Now, Less Later

Above-target inflation, higher commodity prices, and concerns about financial stability prompted the Bank of Canada (BOC) to hasten its rate-hiking cycle. At its 13 April meeting, the BOC raised its policy rate 50 basis points (bps), signaled more hikes to come, and announced plans to reduce its balance sheet.

Buoyed by strong commodity prices, above-trend growth and inflation, a closed output gap, and an expected lag before higher rates affect consumers, BOC officials likely believe the economy can weather a faster hiking cycle. Consumer price index (CPI) inflation surprised consensus expectations and surged 1.4% month over month in March – the fastest pace since 1991. The Canadian economy should also benefit from further reopening tailwinds this year. The BOC’s statement cited excess demand and a tight labor market in justifying a tighter policy stance. The rate hike puts the BOC ahead of the Fed and many other developed market (DM) central banks in tightening monetary policy. The inflation surge in March suggests a hike of 50 bps may come at the BOC’s next meeting on 1 June.

However, relative to some other DM central banks, such as the Federal Reserve, the BOC likely faces higher interest rate sensitivity and more modest underlying inflationary pressures – meaning the BOC may ultimately deliver less tightening.

BOC leads the DM hiking cycle …

A major reason is the nature of mortgages in Canada, where five-year terms predominate. In a typical year about 20% of mortgages mature and require refinancing. That’s a higher proportion than in the U.S. and other DM economies where 30-year fixed-rate loans predominate. Five-year terms mean that households refinancing over the next year likely took out loans in 2017 and 2018 when the BOC was also in the process of hiking rates. As a result, these households are unlikely to face significantly higher payments in the short term from somewhat higher rates. BOC officials also point to improvement in loan-to-income ratios during the pandemic as households used savings and lower interest rates to pay down principal. (For details, please read these recent remarks by BOC Deputy Governor Sharon Kozicki.)

Bottom line: BOC officials can focus on addressing inflation with less concern about near-term downside risks than the overall level of indebtedness would suggest.

… but is likely to lag on tightening over the secular horizon

Although the BOC has outpaced the Fed in tightening thus far, we believe policy rates will ultimately be lower in Canada than other DM economies over the secular horizon. There are several reasons:

• First, the impact of higher interest rates will increase over time. The Canadian economy remains more leveraged than the U.S. economy to both the price of housing and the price of mortgage credit. In general, Canadian consumers have debt-to-income ratios almost twice as high as U.S. consumers. And as noted, interest rate terms for most Canadian mortgages are much shorter, typically five years. Thus, rate increases will affect housing outlays more quickly, eating into other aspects of consumption.
• Second, higher energy prices are providing a tailwind to government finances, and the 2022 budget suggests officials are focused on using these revenues to lower inflation over time through supply-side investment. Proposals to raise labor supply over the long run include investments in green energy, housing, and childcare programs.
• Third, an improvement in the supply side of the economy should, over time, be consistent with less pronounced underlying inflationary pressures than in the U.S. and U.K. While inflation has surged above target across DM economies, wage growth has been more muted in Canada. The labor force participation rate has recovered sharply, and immigration has also helped boost labor supply.
• Finally, unlike in the U.S., Canadian policymakers can, if deemed necessary, use macroprudential tools to address financial stability risks from housing instead of being able to do this only via higher rates.

Higher rates should also help moderate housing activity

We expect sharply higher interest rates, along with a combination of supply-side reforms focused on affordable housing (amid waning affordability), will help cool the Canadian housing market. Given strong starting conditions and low vacancies in many areas, we think this is consistent with house prices stabilizing going into 2023.

For more on central bank policy, see ourInflation and Interest Rates page.

Vinayak Seshasayee is a portfolio manager focused on Canada and Allison Boxer is an economist. Both are regular contributors to the PIMCO Blog.