Mar 4, 2022

Effort to Cool Inflation will Impact Economy, Investments

To take control of Canada’s rapid price increases, early this week, the Bank of Canada (BoC) announced the first increase (25 basis points) to their key policy interest rate since late-2018. In the Bank’s announcement, they also noted that they will keep their reinvestment phase constant until the time is right to allow the size of their balance sheet to decline.

Why Raise Rates Now?

The BoC has increased its trendsetting interest rate because the Bank thinks the Canadian economy is performing well enough to absorb a rate hike. Important macroeconomic indicators show that, too.

For example, the Canadian economy has continued its fast pace of job creation. The latest numbers from Statistics Canada show significant gains from one year earlier. As of January 2022, the Canadian economy had added a little over 890,000 jobs and the national unemployment rate had improved as well falling to 6.5%, almost three percentage points from one year earlier. At the beginning of the year, Canada’s economy had created 585,000 full-time jobs and 305,000 part-time jobs, versus the same period in 2021. The number of full-time jobs created over the past year is nearly double the number of part-time jobs generated over the same time frame. Almost every single job category has experienced significant job gains over the course of 12 months. The entire service sector for example, has created nearly 845,000 new jobs since last year. These facts showcase the broad economic momentum the Canadian economy is carrying.

Household spending continued to rise in earnest, bolstered by job gains, fiscal policy (e.g. COVID-related spending programs) and wage increases. According to Statistics Canada, retail sales were up 1.7% in the fourth quarter of 2021, marking the second consecutive quarterly increase. In volume terms, quarterly retail sales increased 0.4%. Preliminary estimates for January 2022 suggest that sales are expected to land between 2% and 3% showcasing households’ continued demand.

Over the last quarter, wages improved as well. The latest numbers show that average weekly earnings were $1,135 at the end of last year, up by almost 2% on a year-over-year basis. Additionally, Canada’s housing market activity is more elevated than many anticipated and has added further pressure to house prices.

Strong, sustained economic growth continues to support the rationale for raising rates to ensure the economy doesn’t run out of steam. The BoC notes that, at 6.7%, growth in Canada was very strong in the fourth quarter of last year. This rate was greater than the Bank’s projection and confirms their view that economic slack had been absorbed. Despite the strong economic momentum in Canada, one of the biggest reasons for the rate increase has to do with controlling inflation. The main reason for the drastic rise in the price of goods and services over the past year has to do with reopening the economy after a lengthy shutdown. Government-mandated shutdowns inflicted economic pain and many sectors and businesses increased their prices to deal with rising costs pertaining to supply chain issues. Rising prices are also linked to the increase in the amount of money circulating in the financial system. This is a result of federal stimulus packages like the Canada Recovery Benefit (CRB) which helped soften the economic distress from the COVID-19 pandemic. Now, with the conflict unfolding in Eastern Europe, energy prices have continued to rise and the volatility in markets is pushing costs higher, too. As of January 2022, prices rose 5.1% year-over-year. Raising rates will make borrowing more expensive and saving more enticing.

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Are More Rate Hikes Expected?

Despite the positive economic recovery in Canada and across the globe, there are some clouds on the horizon. As the Bank noted in a news release, “the unprovoked invasion of Ukraine by Russia is a major new source of uncertainty. Prices for oil and other commodities have risen sharply. This will add to inflation around the world, and negative impacts on confidence and new supply disruptions could weigh on global growth. Financial market volatility has also increased. The situation remains fluid and we are following events closely.”

The BoC is facing a quandary: continue to raise rates to fight potentially even higher inflation or stand ready to embark in a shallower policy rate hike path given greater economic uncertainty? Notwithstanding the lingering COVID uncertainty and as a result of the war in Ukraine, these events are unlikely to slump and shock global trade significantly. Although Russia’s invasion might cause some instability in European household/business demand in the short run, the economic links between Russia, Ukraine and western nations are not strong enough to endanger the post-pandemic recovery in Europe or cause a full-blown recession. However, if current economic sanctions do little to deter Russia from their invasion of Ukraine, western nations could begin enacting harder sanctions on Russian energy which could cause economic havoc across Europe, and eventually the world.

In light of these risks, the market continues to price between four and five further rate hikes by the BoC this year. In comparison, the U.S. overnight interest rate swap curve has priced in about six rate hikes by the end of 2022. The market-implied probability of an April 2022 BoC interest rate hike stands at 100% as of March 2 (100% market-implied probability of a 25 basis point policy rate hike in the U.S. at their March 16 meeting).

What It All Means

With Canada’s strong positive economic momentum heading into 2022 (AIMCo forecasts 2022 Canadian GDP growth above 4% and average CPI inflation at 3.7%), and despite the risks related to Ukraine and COVID, the hurdle to hike policy rates is low. AIMCo forecasts a total of four policy rates hikes for 2022 (three additional ones for the remainder of the year). Like many, AIMCo expects rate hikes to follow a constant path forward, rising by 25 basis points every increase. We view it unlikely, contrary to market expectations, that the BoC would raise interest rates up to five additional times this year given the elevated household debt burden and its relationship to domestic consumption as well as the negative housing market impact of much higher mortgage rates.

For AIMCo clients’ Fixed Income portfolios, the impact of rising rates could be relatively muted, as positioning is already biased in a short duration manner. Our latest forecast anticipates Canadian 10-year government bond yields to reach about 2.4% by year end.

One thing is certain, the strong economic performance of last year is unlikely to be repeated. The world has to deal with and focus its attention on the conflict between Russia and Ukraine. In addition, the world is still battling COVID-19, its current and future variants. Nevertheless, in Canada, key economic indicators show that the wind is at our back. For instance, the national economy has recouped more jobs than were initially lost to the pandemic. Furthermore, the labour market continues to run hotter-than-expected, and Canadians continue to experience the highest inflation rate in decades. The Bank’s future rate decisions will continue to be guided by their assessment of Canada’s entire economy and their single objective: to keep prices stable and achieve their 2% inflation target.