Could Canada see double-digit interest rates? A look at increasing interest rates, The Bank of Canada and Inflation
In Canada, the burning question on everyone's mind is how high-interest rates will climb and whether we could see a return to the inflationary days of the 1980s. As Inflation persists and the cost of living crisis intensifies, the Bank of Canada (BoC) has taken measures to combat it, raising the policy interest rate by 4.75% since March 2022. While this has shown some positive results in curbing Inflation, the future remains uncertain.
Current State of Affairs
Inflation in June fell to 2.8%, within the BoC's target band of 1% to 3%, though the ideal rate is 2%. However, certain goods, like groceries, remain alarmingly expensive, while gas inflation has fallen due to exceptionally high prices last year. The Consumer Price Index (CPI) surge resulted from various factors, such as supply chain disruptions, soaring commodity prices, and the impact of the COVID-19 pandemic on global economies.
The BoC's decision to increase interest rates has notably impacted Canadians' financial lives. Savers have benefited from rates on guaranteed investment certificates (GICs) above 5%, offering better returns on their savings. However, mortgage holders have experienced steep increases in their payments, with the 5-year fixed mortgage rate surging from under 1.5% in December 2020 to above 5% in July 2023. For instance, on a $500,000 mortgage, the monthly payment has increased by around $1,000.
Challenges in Predicting Interest Rates
Making accurate interest rate predictions for Canada is challenging due to the influence of global events on the nation's economy. Canada's economy is intertwined with the global financial system, and external factors can have significant ripple effects. For instance, geopolitical tensions, trade wars, or extreme weather events can disrupt global supply chains and impact Canada's goods and services' availability and prices. Moreover, as Canada is a significant exporter of commodities like oil and metals, fluctuations in commodity prices can also play an essential role in shaping the country's economic outlook.
Despite differing opinions among experts, the possibility of more rate hikes remains on the table as economic demand remains high, the labor market stays strong, and the housing market shows signs of recovery. Inflation remains a key concern, and the BoC's actions may not sufficiently quell the rising cost of living. Considering domestic and global factors, the central bank must carefully balance economic growth and inflation control.
Potential Return to 1980s-level Inflation
While high Inflation has raised concerns about a repeat of the 1980s, experts believe that comparisons may be exaggerated. The Inflation of the 1980s was driven by a unique combination of factors, including rising oil prices due to the energy crises of the 1970s, increased government spending, and relaxed monetary policy in pursuit of full employment through the 1960s and '70s. This led to higher wages, which further exacerbated the inflation crisis. Additionally, the collapse of the Bretton Woods monetary system in the early 1970s contributed to increased financial supply and rising Inflation.
A crucial difference between the 1980s and the present is inflation targeting. Unlike in the 1980s, the BoC and other central banks now prioritize maintaining a target inflation rate rather than pursuing full employment, contributing to higher Inflation. The BoC's Inflation targeting framework, first implemented in 1991, has successfully managed inflation expectations and prevented uncontrolled price spirals. Furthermore, some experts predict a moderate recession in the second half of 2023, which historically has helped reduce Inflation. During a recession, consumer demand decreases, lowering overall price levels.
Global Headwinds and Impact on Inflation
Several global factors, such as the war in Ukraine, extreme weather events, and China's resurgent economy, could exacerbate inflationary pressures in Canada. Geopolitical tensions, particularly the war in Ukraine, affect global energy markets, affecting oil prices and causing supply chain disruptions. Extreme weather events increase frequency and intensity and can disrupt agricultural production and transportation, leading to higher food prices.
Additionally, the resurgence of China's economy could drive demand for commodities, such as metals and energy, which may result in higher Inflation. China's economic growth has implications for global markets, and any substantial changes could have ripple effects on Canada's export-oriented economy.
Experts also point out other potential risks, such as de-globalization, challenging demographic trends, and possible regulatory or tax changes that support a global move to net-zero emissions. These factors may directly or indirectly impact the Canadian economy and contribute to inflationary pressures.
Feasibility of the BoC's Inflation Target
While debates arose about increasing the BoC's inflation target when Inflation peaked at 8.1% in June 2022, experts now believe the existing target band of 1% to 3% remains suitable. The BoC must maintain credibility, and changing the target could lead to uncertainty and erosion of public trust.
Andrew Grantham, executive director of economics at CIBC Capital Markets, noted, "Changing the target now following such a big spike in inflation would risk the Bank of Canada losing the credibility that it has built up over several decades."
Additionally, any alteration to the inflation target would require a careful assessment of its implications on financial markets, consumer behavior, and the overall economy. If the BoC raises the target band now and Inflation rises further, it may lead to further adjustments, resulting in an arbitrary approach and eroding the BoC's reputation.
In these uncertain times, Canada's interest rates remain at the forefront of economic discussions. While the BoC's efforts to combat Inflation have yielded some success, challenges persist in making accurate predictions. As global headwinds continue to affect the nation's economy, it remains to be seen how high-interest rates will ultimately climb and whether Inflation can be kept in check within the BoC's target band.
Prudent financial decisions should consider the complexity of economic surprises and the potential impact of global events on Canada's inflationary landscape. As history has shown, interest rate predictions are notoriously tricky due to the interplay of multiple factors, both domestic and international. Therefore, Canadians should remain vigilant, adapt to changing economic conditions, and seek professional financial advice to navigate these uncertain times successfully.
Statistics Canada. "Consumer Price Index, June 2023." Accessed on 31st July 2023. (https://www150.statcan.gc.ca/n1/daily-quotidien/230720/cg-a003-eng.htm)
CBC. "Bank of Canada Raises Key Interest Rate to 3.5%, Signals More Hikes to Come." Published on 12th July 2023. (https://www.cbc.ca/news/business/bank-of-canada-interest-rate-decision-july-2023-1.6113720)
Forbes. "Why Canada's Inflation is Skyrocketing and How to Protect Your Portfolio." Published on 17th July 2023. (https://www.forbes.com/advisor/investing/canada-inflation-protect-portfolio/)