The Governing Council of the Bank of Canada (BOC) raised its target for the overnight policy rate by 75 basis points (or 0.75%) today to 3.25% and signaled that the policy rate would rise further.
While some Bay Street analysts believed this would be the last tightening move this cycle, the central bank’s press release has dissuaded them of this notion. There has been a misconception regarding the so-called neutral range for the overnight policy rate. With inflation target at 2%, the BOC economists estimated some time ago that the neutral range for the policy rate was 2%-to-3%, leading some to believe that the BOC would only need to raise their policy target to just above 3%. However, the neutral range is considerably higher, with overall inflation at 7.6% and core inflation measures rising to 5.0%-to-5.5%. In other words, 3.25% is no longer sufficiently restrictive to temper domestic demand to levels consistent with the 2% inflation target.
The BOC points out in today’s statement, though Q2 GDP growth in Canada was slower than expected at 3.3%, domestic demand indicators were robust – “consumption grew by about 9.5%, and business investment was up by close to 12%. With higher mortgage rates, the housing market is pulling back as anticipated, following unsustainable growth during the pandemic.”
Wage rates continue to rise, and labour markets are exceptionally tight, with job vacancies at record levels. But the Bank is concerned that rising inflation expectations risk embedding wage and price gains. To forestall this, the policy interest rate will need to rise further.
Markets are now betting that another 50 basis points (or 0.50%) rate hike is likely when the Governing Council meets again on October 25th. There is another meeting this year on December 6th and we expect the policy rate to end the year at 4%.
The implications of today’s Bank of Canada action are considerable for the housing market. The prime rate will now quickly rise to 5.45%, increasing the variable mortgage interest rate another 0.75%, which will likely take the qualifying rate (stress test rate) to roughly 7%.
Fixed mortgage rates, tied to the 5-year government of Canada bond yield, will also rise, but not nearly as much. It is noteworthy that the BOC omitted the usual comment on a soft landing in the economy in today’s press release. Economists realize that the price paid for inflation control might well be at least a mild recession.
Another implication of today’s policy rate hike is the prospect of fixed-payment variable-rate mortgages taken in 2021 and 2022, are hitting their trigger rate. There is a good deal of uncertainty around how many these will be, as the terms vary from loan to loan.
We maintain the view that the economy will slow considerably in the second half of this year and through much of 2023. The Bank of Canada will hold the target policy rate at its high point (at least one or two hikes away) through much of 2023. A return to 2% inflation will not occur until at least 2024.