The Bank of Canada hiked interest rates by a full percentage point, a surprise move that supercharges efforts to withdraw stimulus before four-decade-high inflation becomes entrenched.
Governor Tiff Macklem raised the central bank’s policy rate to 2.5 per cent in a decision announced Wednesday in Ottawa that warned of more hikes to come. The 100-basis-point move is the largest increase since 1998. Markets and economists were anticipating 75 basis points.
The unexpected move illustrates the extent to which officials are spooked by soaring inflation taking hold of expectations, electing to take decisive action even at the risk of causing severe economic pain.
“With the economy clearly in excess demand, inflation high and broadening, and more businesses and consumers expecting high inflation to persist for longer, the Governing Council decided to front-load the path to higher interest rates,” officials said in the policy statement.
To explain the aggressive move, policy makers cited an economy “clearly in excess demand,” high and broadening consumer price gains and growing inflation expectations. Officials said they expect to continue raising interest rates further and will be “resolute” on bringing inflation back to target.
Still, policy makers indicated they believe front-loading rates would actually limit economic damage in the long run, by reducing the need to chase escalating inflation expectations in the future.
In the statement, the bank said “the economic cost of restoring price stability will be higher” if inflation becomes entrenched in wage and price setting expectations.
The 100-basis-point increase follows consecutive half-percentage-point hikes in April and June, making the current tightening effort one of the most aggressive ever. Wednesday's super-sized increase brings rates into the neutral range, where borrowing costs are neither stimulative nor constrictive.
Before the decision, overnight swap trading was pricing in a policy rate of at least 3.5 per cent by the end of the year.
In the accompanying monetary policy report, officials again raised their near-term forecasts for inflation, seeing price pressures running at around 8 per cent in the middle quarters of this year. Inflation will drop to 7.5 per cent by the end of this year, and won't return to the 2 per cent target until the end of 2024.
Policy makers also slashed their outlook for the Canadian economy. They now see gross domestic product expanding 3.5 per cent this year and 1.8 per cent in 2023, down from 4.2 per cent and 3.2 per cent respectively, as global growth moderates and tighter monetary policy impacts activity.
The bank added analysis of a new risk scenario, in which a “self-reinforcing wage hike and price spiral” could ensue, saying that situation becomes more likely the longer inflation remains “well above” their 2 per cent target.
In an appendix to the report, the bank acknowledged mistakes in forecasting inflation over the last year. It primarily blamed the errors on global factors, but also cited domestic housing costs.
The bank said real-estate activity has already weakened substantially from what it described as an “unsustainable pace” during the pandemic. It expects both housing transactions and prices to decline into 2023 as interest rates rise.
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