After five months on the sidelines, the Bank of Canada was pushed back into action this week by surprisingly strong consumer spending data and worrying signs that the downward trend in inflation has begun to stall, Paul Beaudry, one of the bank’s deputy governors, said Thursday.
The central bank raised its benchmark interest rate by a quarter percentage point on Wednesday. That lifted the policy rate to 4.75 per cent, the highest level since 2001, and restarted the bank’s monetary policy tightening campaign, which had been on hold since January.
“When we looked at the recent dynamics in core inflation combined with ongoing excess demand, we agreed the likelihood that total inflation could get stuck well above the 2-per-cent target had increased,” Mr. Beaudry told the Greater Victoria Chamber of Commerce, according to the prepared text of the speech.
He gave no indication of where interest rates are heading in the near term, or whether the bank intends to hike its benchmark rate again in July or September, as many Bay Street analysts now believe it will. But he did say that, over the long run, interest rates may be higher than before the COVID-19 pandemic, because of structural changes in the global economy.
The bank had announced a “conditional pause” to interest-rate increases earlier this year, saying it believed that borrowing costs were high enough, after eight consecutive hikes, to slow the economy and bring down inflation over time. Rate increases work with a considerable lag, and most economists at the central bank and on Bay Street were expecting the accumulation of hikes to bring economic growth to a standstill through the first half of 2023.
Instead, the economy has proven to be remarkably resilient to higher borrowing costs. GDP growth exceeded expectations in the first quarter, unemployment remains near a record low and housing market activity has begun to rebound.
“Consumption growth, in particular, was very strong at 5.8 per cent [in the first quarter], with household spending on both goods and services sharply higher. This surprised us,” Mr. Beaudry said Thursday. The speech was his last before his planned retirement from the central bank next month.
“We had expected growth in demand for services to start to ease off, but Canadians continue to catch up on travel, entertainment and restaurant spending,” he said. “More unexpected was the strength of the rebound in goods spending, particularly demand for interest-rate-sensitive goods, like furniture and appliances.”
He said the bank’s governing council also discussed the continuing tightness of the labour market, which is pushing up wages and feeding through into service price inflation.
Simply put, the economy is much stronger than the central bank would like it to be at this point in the business cycle. It is intentionally trying to dampen consumer spending and business investment, and to push up unemployment, to reduce upward pressures on prices.
In a news conference after the speech, Mr. Beaudry said rate hikes appear to be squeezing consumers less than expected. He pointed to several possible explanations, including the fact that commercial banks are allowing variable-rate mortgage holders to extend their amortization periods rather than pay more each month, and the tightness in the labour market.
“We do think this very vigorous labour market is a big part that is keeping that consumption up,” he said, while acknowledging that the central bank was still trying to figure out why monetary policy tightening is working more slowly than expected.
Inflation has trended down since last summer, with the annual rate of consumer price index inflation falling to 4.4 per cent in April from 8.1 per cent last June. Central bank economists expect the rate of inflation to drop to 3 per cent this summer, dragged down by year-over-year oil price comparisons. But they’re worried that inflation could get stuck above 2 per cent.
On this front, inflation data from April were concerning. The headline inflation rate ticked up from 4.3 per cent in March to 4.4 per cent in April.
“While that might not seem like much, it was in the opposite direction of what we expected, and the details behind the headline number were concerning,” Mr. Beaudry said.
“In particular, three-month measures of core inflation remain elevated and seem to have lost their downward momentum. And goods inflation surprised us by accelerating in April, reversing course after months of deceleration.”
Mr. Beaudry shrugged off questions about where interest rates are going in the near-term, saying only that the bank is moving decision by decision. He devoted much of his speech to the longer-term question of whether Canada, and the world, is entering an era of persistently higher interest rates.
The evidence is unclear, and the debate is largely academic. But Mr. Beaudry argued there’s good reason to believe interest rates could be higher than in the prepandemic era. Forces that have pulled interest rates lower for decades – including demographic trends, the entrance of China into the international economic system, and the rise of inequality – may be stalling or even reversing.
“That makes it unlikely the real neutral rate will fall below prepandemic estimates and creates a meaningful risk that it could go up,” Mr. Beaudry said. The neutral rate is the theoretical resting place for interest rates, when inflation is on target and the economy is growing at its full potential. The bank currently estimates the neutral rate is between 2 per cent and 3 per cent.
“In the bank’s view, that makes it more likely that long-term real interest rates will remain elevated relative to their prepandemic levels than the opposite,” he added.
These are long-term trends, and the bank’s policy rate will continue to fluctuate around the neutral rate, depending on the business cycle. But Mr. Beaudry said it’s worth keeping these tectonic changes in mind.
“You only need to look to the recent stresses in the global banking sector to see examples of poor planning for the possibility of higher rates,” he said.