Economic update: The BoC’s January interest rate increase

The last year has seen the Bank of Canada raise interest rates several times, taking its policy rate from just 0.25% in March of 2022 to 4.25% by December year end. In late January 2023, another 0.25% increase was announced, but it appears that the rate hiking cycle is set to slow for now. Our colleagues at NEI Investments released an update on the recent increase and the state of the Canadian economy.

Bank of Canada hikes rate by 25 basis points

On January 25, the Bank of Canada (BoC) announced another interest rate hike, lifting the overnight policy interest rate by 25 basis points (bps) to 4.50%, which was consistent with consensus estimates. The move was the eighth consecutive hike since last year and represented a slowdown in the pace of increases since the start of the rate hiking cycle. The impact of restrictive rates is becoming clearer in the economy as consumption growth has slowed and housing market activity has moderated. The BoC’s forward guidance included new language to suggest that there could now be a pause in the rate hiking cycle. “If economic developments evolve broadly in line with the MPR (Monetary Policy Report) outlook, Governing Council expects to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases.” However, the statement did leave room for further hikes “if needed to return inflation to the 2% target.”

While the BoC’s rate statement suggests a pause-and-hold approach in the near term, the overnight swap market continues to price-in a possible rate cut in October 2023. The yield on the Government of Canada 10-year bond rose moments following the news, but later settled lower as the market continued to digest the information. On the equities side, market reaction was moderately positive following the rate announcement and the markets recovered part of their overnight losses.

GDP forecast raised slightly from 0.9% to 1% in 2023

In the recently released Monetary Policy Report, the BoC estimates Canada’s economy grew by 3.6% in 2022, slightly stronger than was projected in October. The BoC projects a slow first half of the year, however economic growth is expected to pick up in the latter part of 2023. GDP growth is projected to be 1% in 2023 and about 2% in 2024, little changed from the October outlook.

Inflation has turned the corner

Inflation remains high and broad-based at 6.3% and core inflation at 5% in December. However, CPI has declined in recent months as price declines in used cars are now helping to offset the inflationary pressures on rent and shelter. While there continues to be excess demand, improvements in the global supply chain and the effects of higher interest rates are bringing supply and demand dynamics closer to equilibrium. Inflation has declined from 8.1% in June 2022, reflecting lower gasoline prices and, more recently, moderating prices for durable goods. 

According to Bank of Canada, "Year-over-year measures of core inflation are still around 5%, but 3-month measures of core inflation have come down, suggesting that core inflation has peaked."  With lower energy prices, improvements in global supply conditions, and the dampening effects of higher interest rates on demand, BoC expects inflation to fall to 3.6% in 2023 and to 2.3% by 2024.

Year-over-Year inflation remains high, but 3-month inflation has rolled over.

Inflation in the price of services has not adjusted as quickly as anticipated. The BoC acknowledged that labour markets are still tight, with the unemployment rate near historic lows and businesses reporting ongoing difficulty finding workers. Labour cost growth may be higher and more persistent than projected. This could also happen if productivity growth rebounds more slowly than expected, for instance, if business investment is weaker than anticipated. The labour market could also remain tight for longer than projected. Unit labour cost has been growing well above what would be consistent with reaching the 2% inflation target.