Market Wire: Bank of Canada hikes, moves forecasts higher

As had been widely expected, the Bank of Canada raised its benchmark overnight rate to 5 percent this morning, pointing to signs of excess demand and still-stubborn underlying inflation pressures in justifying a tighter policy stance.

In the accompanying statement, officials said growth has been “stronger than expected, with more momentum in demand… While the Bank expects consumer spending to slow in response to the cumulative increase in interest rates, recent retail trade and other data suggest more persistent excess demand in the economy. In addition, the housing market has seen some pickup. New construction and real estate listings are lagging demand, which is adding pressure to prices”.

Echoing observations made by many economists in recent months, the Bank acknowledged the impact of shifts in Canada’s demographic situation, saying “Strong population growth from immigration is adding both demand and supply to the economy: newcomers are helping to ease the shortage of workers while also boosting consumer spending and adding to demand for housing”.

The statement highlighted stubbornly-sticky core inflation in motivating additional policy tightening, pointing out that three-month growth rates in its preferred core measures have been running at between 3.5 and 4 percent since last September, suggesting that “underlying price pressures appear to be more persistent than anticipated”.

According to updated forecasts contained in the Monetary Policy Report, the economy is expected to expand 1.8 percent this year—up from the 1.4 percent previously estimated in April—and 1.2 percent in 2024. Inflation is seen running at 3 percent for much of the next year before gradually declining to 2 percent in the middle of 2025. Officials warned “This is a slower return to target than was forecast in the January and April projections” and said “Governing Council remains concerned that progress towards the 2 percent target could stall, jeopardizing the return to price stability”.

Although the headline move was largely priced in ahead of the decision, gains have been relatively significant: two-year yields pushed sharply higher and the Canadian dollar climbed almost 35 basis points in the moments after the announcement as investors responded to the more hawkish forecasts contained in the Monetary Policy Report.

Adding to the Canadian dollar’s gains, the US dollar is trading substantially softer after numbers released earlier this morning showed inflation dropping to 3 percent in June - well below expectations. With price growth showing clear signs of rolling over at both the headline and core levels, investors are positioning for a moderation in the hawkish rhetoric from Federal Reserve officials in coming months, and are downgrading the likelihood of further tightening beyond July. Futures curves suggest that expectations for a hike in a few weeks remain firm, but odds on an autumn move have plummeted toward zero, and markets are beginning to incorporate cuts in early 2024.