This is 50

By Taylor Schleich /Jocelyn Paquet/Warren Lovely

National Bank of Canada, Financial Markets

Rate Statement

For the second consecutive meeting, the Bank of Canada opted to increase its overnight rate target. Unlike in March when the Bank hiked by 25 basis points, today’s rate increase was 50 basis points—the first time in over 20 years a hike larger than 25 bps was announced. The decision, which was in line with consensus, brings the overnight target to 1%. Consistent with last month’s hike, the Bank also raised its deposit rate proportional to the overnight target (i.e., by 50 bps to 1%. In ‘normal times’ the deposit rate is set 25 basis points below the overnight target).

As for interest rate guidance, the statement reiterated that “interest rates will need to rise further” (unchanged from March). The statement did add that the economy is “moving into excess demand” and that inflation is “persisting well above target”, leaving the door open to future 50 basis point hikes.

When it comes to the BoC’s balance sheet, the statement also ushered in the start of quantitative tightening. Effective April 25th, reinvestment purchases will cease and the Bank will allow its maturating GoC bond holdings to roll off the balance sheet. The Bank has $85 billion in bonds maturing this fiscal year, which in addition to the net bond supply signaled in last week’s federal budget/Debt Management Strategy, will mean a record slug of bonds that will be needed to be absorbed by non-BoC buyers.

Elsewhere in the statement, the Bank highlighted the upwardly revised inflation trajectory (explored in more detail below), being driven by ongoing supply disruptions and commodity price increases resulting from the Russian invasion of Ukraine. Growth in Canada is “strong” and the economy is “moving into excess demand”. Labour markets “are tight” and wage growth is “back to its pre-pandemic pace and rising”. The statement notes that consumer spending is “strengthening”, investment and exports “will continue to recover” and housing activity is “expected to moderate”. Critically, the Bank believes that “robust” investment and productivity growth, in addition to higher immigration, will “add to the economy’s productive capacity”, justifying their increased neutral rate projection. On inflation, they note that there’s “an increasing risk that expectations of elevated inflation could become entrenched”.

Market Notice on Quantitative Tightening

In a Market Notice, the Bank provided some additional clarity on the imminent QT episode. Clearing up earlier confusion, “the Bank will not be purchasing Government of Canada bonds in the primary or secondary markets”. As for how long it can run down its balance sheet: “The longerrun level of settlement balances is yet to be determined, but it is far lower than the current level.” This assessment will be driven by money market indicators and input from market participants. The Bank also added that it will continue to implement policy via a floor system (i.e., the overnight target being set equal to the deposit rate) and this “will remain in place even after quantitative tightening has run its course”.

Monetary Policy Report

The central bank also released the latest edition of its Monetary Policy Report (MPR). The MPR emphasized growing uncertainty, particularly with regards to Russia’s invasion of Ukraine which risks disrupting the global recovery just as most economies are emerging from the impact of the Omicron variant. Slowing growth in China caused by the imposition of strict health measures in several cities was also cited as a risk factor for the global outlook. In this context the BoC decided to downgrade its global growth forecast for 2022 (from 3.6% to 3.5%) and 2023 (from 3.4% to 2.5%), with the biggest impacts being felt in oil-importing economies and regions with closer ties with Russia.

Turning to Canada, the BoC acknowledged “strong” economic momentum and a “robust” labour market. It now expects GDP to expand 4.2% in 2022, more than the 4.0% penciled in the previous MPR. This upward revision was made to reflect the removal of public health restrictions, solid foreign demand for Canadian products and higher commodity prices. Further down the horizon, the BoC anticipated GDP to expand 3.2% in 2023 (down from 3.5% in the previous MPR) and 2.2% in 2024. Overall, these revisions left the level of real GDP at the end of 2023 roughly unchanged compared with the previous estimate. The central bank also mentioned that these projections did not incorporate the measures announced in the April 2022 federal budget, which are assumed to have a modestly positive impact on growth. As for the output gap, the bank estimated it at around -0.25%-0.75% in the first quarter, higher than the estimate of ‑0.75% to 0.25% for the fourth quarter of 2021.

As expected, policymakers significantly increased their CPI inflation projection for this year (from 4.2% to 5.3%) and next (from 2.3% to 2.8%). “Factors driving inflation include sharp increases in energy and food prices as well as supply disruptions and strong demand for goods”, the MPR stated. The central bank expected inflation to average just below 6% through the first half of 2022 and remain well above the control range through the rest of the year. It then anticipated a steady decline to about 2.5% in the second half of 2023 and to the 2% target in 2024. It is worth noting that these forecasts incorporated a steady decline in oil prices.

The Bank also revised its estimate of the neutral nominal policy interest rate from 1.75%-2.75% to 2.00%-3.00%. The change was made to reflect a combination of a higher global neutral rate (the small open nature of the Canadian economy implies that its neutral rate is linked with the global neutral rate) and a stronger outlook for potential output.

Press Conference

The post-meeting press conference was a bit of a dud with only a few notable soundbites worth highlighting. Importantly, Macklem told Canadians that they should expect interest rates “to continue rise to more normal settings… By more normal we mean within the range we consider for a neutral rate of interest (2% to 3%)”. On whether or not the Bank would have to hike above neutral, Macklem didn’t rule out the possibility: “We may need to take rates modestly above neutral for a period to bring demand and supply back to balance and inflation back to target”. But at the same time, he conceded that “if demand responds quickly to higher rates and inflationary pressures moderate it may be appropriate to pause our tightening when we get closer to the neutral rate.” This ambiguous/flexible approach employed by Macklem stands in contrast to the FOMC who has clearly signaled its intention to bring the policy rate above neutral for a sustained period of time. He also reiterated prior statements from the Bank that they’re “prepared to move as forcefully as needed”, adding “it’s clear we have more work to do.” When asked about the ability for Canadian households to withstand higher interest rate, Senior Deputy Governor Carolyn Rogers said they’re confident that they are, pointing to built-up excess savings.

Bottom Line

In addition to the first 50 basis point rate hike since 2000, the Bank of Canada ushered in the start of quantitative tightening which will see its GoC bond purchases cease at the end of next week. Clearing up earlier confusion, this means there will be no GoC bond purchases whatsoever, including in the primary market. Supported by an even stronger inflation outlook, the tone of the rate statement remained decidedly hawkish. As for the near-tern outlook, the bar for a second consecutive 50 basis point hike isn’t particularly high in our view. Should April labour market data show continued tightening and if the March/April CPI reports don’t show signs of easing, 50 bps should be viewed as the most likely outcome in seven weeks. As for more medium-term guidance for the policy rate, the statement reiterated that “rates will need to rise further”, while in the press conference, Macklem said that Canadians can expect interest rates to increase to the range they consider neutral. On this front, we did see the BoC increase their estimate of neutral to a 2% to 3% range, despite speculation that it could be decreased. We tend to view neutral as being at the lower end of that range and remain skeptical that we will see the policy rate rise to, or above, the upper bound of its estimates, as has been priced by markets in recent weeks.

We do, however, expect that the Bank will be hiking at every meeting through the third quarter of the year and see the policy rate ending the year at no less than 2%. When it comes to QT, the incoming increase in net supply to the street will indeed drain excess liquidity from the system. However, its potential impact has been dulled somewhat given that (a) the GoC‘s issuance target came out lower than expected; and (b) the Government moved a significant amount of planned issuance from the long end of the curve to the short end. Indeed, we continue to the view the policy rate as the most important and most impactful tool at the BoC’s disposal.

The Bank’s next policy meeting is scheduled for June 1st. There will be no Monetary Policy Report released at that meeting.

Full pdf version of report:

2022-04-13-NBIN-BoC Policy Monitor

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