We might be planting the seed for higher inflation: Economist
Traders are betting that the Bank of Canada will be forced into raising interest rates earlier than expected, posing one of the stiffest tests yet for Governor Tiff Macklem.
Bets in the overnight swaps market are increasingly tilting toward a move early next year, well ahead of the U.S. Federal Reserve. Traders have now priced in three hikes in Canada by the end of 2022, which would bring the policy rate to 1 per cent from the current 0.25 per cent.
That’s about 50 basis points higher than markets were expecting just a month ago. The shift in pricing is increasingly at odds with Macklem’s guidance that borrowing costs won’t increase until slack is absorbed and inflation returns sustainably to its target range.
The bank has said repeatedly it doesn’t see that happening until the second half of next year.
Analysts are warning that the uncertainty surrounding liftoff in Canada could undermine the effectiveness of the bank’s forward guidance.
“If Macklem capitulates around an early rate hike when he thinks spare capacity might still exist then the whole exit framework will turn into a dumpster fire,” Derek Holt, an economist at Bank of Nova Scotia in Toronto, said by email. “It could make forward guidance a very weak tool in future and magnify risks to policy efficacy.”
Part of the shift in bets, which has also occurred for the Fed and European Central Bank, is due to price pressures proving more persistent than expected.
Statistics Canada is due to report inflation data for September on Wednesday. Economists surveyed by Bloomberg expect the yearly rate will hit 4.3 per cent, the highest level in nearly two decades and the sixth straight month of readings beyond the central bank’s 3 per cent cap.
On Monday, the Bank of Canada’s quarterly business outlook survey revealed a record 45 per cent of respondents expect inflation above 3 per cent over the next two years. More than 85 per cent see prices rising faster than the bank’s 2 per cent target.
“Acting a bit sooner into the second half of 2022 seems like the justifiable course of action,” Jimmy Jean, chief economist at Desjardins Securities Inc., said Monday in a report to investors in which he changed his forecast for the first rate increase to July, instead of October. That could “help address the risk that persistent inflationary pressures cause a more profound and lasting upward shift in inflation expectations,” he said.
“The market is testing the Bank of Canada’s resolve on forward guidance,” Andrew Kelvin, chief Canada strategist at Toronto-Dominion Bank’s securities unit, said by email. His team sees the central bank hiking in July, a call brought forward from October just last week.
“The closer we get to liftoff, we will see pressure grow on the BoC to break away from their forward guidance. It can be difficult to evaluate the strength of the BoC’s commitment.”
Macklem has, however, changed the bank’s tune on inflation somewhat. While he maintains it’s a temporary phenomenon, the governor said after an Oct. 7 speech that price pressures have become more persistent than the bank initially expected.
He repeated that point again last week. “Measures of inflation are probably going to take a little longer to come back down,” Macklem told reporters during a video roundtable from Washington after the International Monetary Fund’s annual meetings.
The bank’s next decision is due Oct. 27. No move on borrowing costs is expected, but Macklem will likely pare back weekly purchase of Canadian government bonds to $1 billion (US$810 million) from the current pace of $2 billion. All eyes will be on any changes in language on rate guidance, as well as the inflation outlook in the latest quarterly economic forecasts.
“Either markets are not listening to the bank’s communications around its exit framework, or they don’t believe its argument that we still have slack in the economy given price and nascent wage pressures,” Holt said.