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Canadian Central Bank Says Economy can Handle Higher Rates

In: Finance, Forex

Policymakers led by Governor Tiff Macklem increased the central bank’s overnight benchmark to 1% on Wednesday. Macklem said he expects rates will return to what they consider the “neutral range” of 2% and 3%, with policy makers prepared to move “forcefully” if needed.

Macklem said at a news conference in Ottawa: “The economy can handle higher interest rates, and they are needed.”

The Bank of Canada raised its key interest rate by half a percentage point in its biggest hike in 22 years, and said rates are poised to move significantly higher as it aggressively wrestles inflation down from a three-decade high.

The bank also said it will stop purchasing government bonds later this month to start shrinking its balance sheet, another form of stimulus withdrawal.

The loonie strengthened, gaining 0.4% to C$1.2593 per U.S. dollar in Toronto trading. Short-term bonds fell after the report, pushing Canada’s benchmark two-year yield to as high as 2.346%, before reversing those losses.

The policy actions mark an acceleration of what’s expected to be one of the most aggressive monetary tightening campaigns ever by the Bank of Canada, a tacit recognition from the central bank that it needs to quickly exit from ultra-loose policy before inflation becomes sticky.

“There is an increasing risk that expectations of elevated inflation could become entrenched,” officials said in the rate statement, adding the bank will “use its monetary tools to return inflation to target and keep inflation expectations well-anchored.”

In what policymakers described as a “substantial upward revision,” inflation is now seen averaging near 6% in the first half of 2022, before easing to about 2.5% in the second half of next year and to around its 2% target by the end of 2024.

Inflation is projected to average 5.3% in 2022, versus forecasts in January of 4.2%. Price growth will slow to 2.8% on average in 2023, versus previous forecasts of 2.3%.

Over the next 12 months, about a quarter of the net C$350 billion ($275 billion) in government debt acquired during the pandemic will mature, pushing up yields, and complementing the increase in the policy rate. The Bank of Canada also provided some details of its quantitative tightening plan on Wednesday.

The bank no longer plans to replace federal bonds as they roll off their balance sheet starting April 25. Officials are also assuming Canada’s economy won’t be negatively impacted by the Ukraine crisis thanks to the nation’s commodities sector, while global inflationary pressures are seen eventually abating. If the latter assumption fails to materialize, the rate-hike path would need to be more aggressive.

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