Interest rate increases could be bigger – and sooner – due to inflation, warns Bank of Canada deputy governor

The Bank of Canada in Ottawa on May 16, 2019.Sean Kilpatrick/The Canadian Press

Bank of Canada deputy governor Sharon Kozicki hinted Friday that a half-percentage-point interest rate increase may be on the table for the central bank’s upcoming rate decision in mid-April.

In her first speech since joining the bank’s governing council last summer, Ms. Kozicki said the central bank is “prepared to act forcefully” to bring high inflation under control. She also argued that Canadian households are better prepared to manage rising interest rates than they were during the last rate hike cycle in 2017 and 2018.

“I expect the pace and magnitude of interest rate increases and the start of [quantitative tightening] to be active parts of our deliberations at our next decision in April,” she said in a keynote speech delivered to the Federal Reserve Bank of San Francisco’s monetary policy conference. Quantitative tightening refers to the central bank shrinking its holdings of government bonds.

“The reasons are straightforward: Inflation in Canada is too high, labor markets are tight and there is considerable momentum in demand,” Ms. Kozicki said.

This follows comments from Bank of Canada Governor Tiff Macklem in early March that the bank is not ruling out a 0.5-percentage-point rate increase instead of the usual 0.25 percentage points – something that hasn’t happened since May, 2000.

After holding interest rates near zero for two years, the Bank of Canada kicked off a monetary policy tightening cycle in early March. It raised its policy interest rate to 0.5 per cent from 0.25 per cent and signaled more rate hikes are imminent.

Economists and investors expect the bank to move quickly. Financial instruments that track market expectations about rate hikes suggest the bank will raise its policy rate at each of its six remaining decision dates in 2022. That would move the policy rate above its prepandemic level of 1.75 per cent.

Royce Mendes, head of macro strategy at Desjardins, said Ms. Kozicki’s hawkish remarks on Friday put a half-percentage-point hike in play for the April 13 rate decision.

“We continue to believe that the Bank of Canada will augment a 25-basis-point hike in April with the beginning of its quantitative tightening program. However, the risks are tilted towards both a faster pace and higher terminal rate for this cycle than the 2-per-cent peak we currently have penciled in,” Mr. Mendes wrote in a note to clients about the speech.

The Bank of Canada is contending with runaway inflation, which hit an annual rate of 5.7 per cent in February – nearly three times higher than the bank’s 2 per cent inflation target. Rising oil and agricultural commodity prices, which have soared as a result of Russia’s invasion of Ukraine, are putting additional upward pressure on inflation.

“With everyday items such as gas and groceries facing some of the fastest price gains, all households are affected by high inflation. But my colleagues and I are mindful that this is especially painful for those with low incomes, because they tend to spend a greater share of their earnings on such items,” Ms. Kozicki said.

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Persistently high inflation has forced Canada’s central bankers to pivot hard away from the accommodative stance they maintained through much of the COVID-19 pandemic. The US Federal Reserve has taken an even more abrupt turn.

After the Fed raised its policy rate last week for the first time since cutting it at the outset of the pandemic, chair Jerome Powell said this week that the central bank needs to move “expeditiously” toward tighter monetary policy. Markets are now pricing in several 0.5-percentage-point hikes from the Fed this year.

Ms. Kozicki’s speech painted a mixed picture of how Canadian households may be impacted by rapidly rising interest rates. On the one hand, Canadians on average saved a considerable amount of money over the past two years, as a result of generous government support and lower spending due to health lockdowns. That could help cushion the impact of rising monthly interest payments.

Moreover, most Canadian homeowners have fixed-rate mortgages, which means they won’t see monthly payments increase until they renew their mortgage agreements.

At the same time, overall household indebtedness is above prepandemic levels, thanks in large part to ballooning real estate prices. That amounts to “an important domestic vulnerability,” Ms. Kozicki said.

“High indebtedness could amplify the impact of rising interest rates, and it could also worsen the impact of a future shock,” she said, noting that people who stretched to take on mortgage debt – particularly variable-rate mortgages – could be squeezed by higher monthly payments, which would force them to reduce their consumption of other goods and services.

“If enough of them were to slow their spending materially, it could affect the whole economy, such as by slowing growth or increasing unemployment. A drop in house prices could worsen these effects,” she said.

We balance, she said Canadian households are in better financial shape now than at the start of the bank’s last rate tightening cycle in 2017.

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