Bank of Canada hikes economic forecast, opening door to rate hike in 2022

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Canada’s central bank has decided to ease back on the throttle, given that revised calculations show the economy is on a much better trajectory than policy-makers anticipated at the start of the year.

Policy-makers said the improved outlook implies higher interest rates in the second half of 2022, instead of their previous assumption that they would need to keep the benchmark rate near zero until sometime in 2023 to bring about a sustained recovery. They also said they would taper their purchases of federal debt starting next week.

To be sure, the third wave of coronavirus infections is cause for concern at the central bank. It also remains unusually difficult to get a read on where the economy is headed, because of the upheaval that has come in the wake of the pandemic. The Bank of Canada emphasized in its latest batch of communications on April 21 that “achieving a full recovery will take time,” and that “strong and sustained growth will be needed to overcome the pandemic’s severe economic impacts.”

In other words, governor Tiff Macklem will do what he needs to do to keep interest rates unusually low for a longer period of time than an orthodox approach to monetary policy would imply is appropriate. “Even as economic prospects improve, the Governing Council judges that there is still considerable excess capacity, and the recovery continues to require extraordinary monetary policy support,” the central bank said in an updated policy statement.

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Still, it’s worth remembering that entrepreneurs, executives and consumers always find ways to adapt. Rather than buckle in the face of the second onslaught of COVID-19 last winter, the economy pushed ahead, posting an annual growth rate of seven per cent in the first quarter, crushing the central bank’s previous prediction of a contraction.

Overall, the central bank said it now predicts that gross domestic product will grow at 6.5 per cent this year, compared with its previous estimate of four per cent, led by household consumption, housing, exports and extraordinary government spending. That means the economy is on track to fill in the massive hole left by the COVID-19 recession by the end of the year, which would mark a swifter recovery than occurred after the Great Recession a decade ago.

The Bank of Canada is pointedly refusing to declare victory, but given those relatively happy facts, its leaders concluded their latest round of interest-rate deliberations with a decision to begin withdrawing some of their extraordinary stimulus. Macklem and his deputies said the bank would reduce its weekly purchases of Government of Canada bonds to $3 billion from $4 billion, a first step toward ending an extraordinary policy known as quantitative easing (QE) and putting it back in the armoury.

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“This adjustment to the amount of incremental stimulus being added each week reflects the progress made in the economic recovery,” the Bank of Canada said.

Policy-markers remain troubled by the outlook. There are still 300,000 fewer people working today than at the beginning of the pandemic, and the Bank of Canada noted the shortfall is actually about 475,000 if you take into account where population growth would have pushed employment if not for the epic recession.

Behavioural changes, such as the shift to e-commerce and increased working from home, will probably lead to structural changes that aren’t reflected in the central bank’s history-based models. That makes trying to predict the future harder. “The recovery remains highly dependent on the evolution of the pandemic and the pace of vaccinations,” the central bank said.

The central bank will proceed slowly, but it can’t deny the growing number of positives. The United States’ economy will expand seven per cent this year and China’s will grow an astounding 9.5 per cent, upwardly revised from five per cent and 8.4 per cent, respectively, according to the Bank of Canada’s forecast.

Outsized demand from the world’s two economic superpowers has pushed commodity prices higher, and implies strong orders for the kinds of goods and services that Canada produces. Higher oil prices will push the value of the Canadian dollar higher, but the gains from trade will “substantially exceed” the headwinds a stronger currency will create for some exporters, the Bank of Canada said in its latest quarterly report on the economy.

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Early signs suggest that household spending will be strong, and the Bank of Canada foresees elevated levels of investment as companies retool for the digital economy. The other recovery engine is the housing market, which will contribute 1.9 percentage points to overall GDP growth this year, compared with an early estimate of 0.7 percentage points. Policy-makers said they think the stunning surge is mostly the result of a shift in demand for larger homes that will eventually be balanced out by increased supply. But they acknowledged that there’s a risk of overheating.

“Housing construction and resales are at historic highs, driven by the desire for more living space, low mortgage rates, and limited supply,” policy-makers said. “The bank will continue to monitor the potential risks associated with the rapid rise in house prices.”

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