Above-target inflation, higher commodity prices, and concerns about financial stability prompted the Bank of Canada (BOC) to hasten its rate-hiking cycle. At its 13 April meeting, the BOC raised its policy rate 50 basis points (bps), signaled more hikes to come, and announced plans to reduce its balance sheet.
Buoyed by strong commodity prices, above-trend growth and inflation, a closed output gap, and an expected lag before higher rates affect consumers, BOC officials likely believe the economy can weather a faster hiking cycle. Consumer price index (CPI) inflation surprised consensus expectations and surged 1.4% month over month in March – the fastest pace since 1991. The Canadian economy should also benefit from further reopening tailwinds this year. The BOC’s statement cited excess demand and a tight labor market in justifying a tighter policy stance. The rate hike puts the BOC ahead of the Fed and many other developed market (DM) central banks in tightening monetary policy. The inflation surge in March suggests a hike of 50 bps may come at the BOC’s next meeting on 1 June.
However, relative to some other DM central banks, such as the Federal Reserve, the BOC likely faces higher interest rate sensitivity and more modest underlying inflationary pressures – meaning the BOC may ultimately deliver less tightening.
BOC leads the DM hiking cycle …
A major reason is the nature of mortgages in Canada, where five-year terms predominate. In a typical year about 20% of mortgages mature and require refinancing. That’s a higher proportion than in the U.S. and other DM economies where 30-year fixed-rate loans predominate. Five-year terms mean that households refinancing over the next year likely took out loans in 2017 and 2018 when the BOC was also in the process of hiking rates. As a result, these households are unlikely to face significantly higher payments in the short term from somewhat higher rates. BOC officials also point to improvement in loan-to-income ratios during the pandemic as households used savings and lower interest rates to pay down principal. (For details, please read these recent remarks by BOC Deputy Governor Sharon Kozicki.)
Bottom line: BOC officials can focus on addressing inflation with less concern about near-term downside risks than the overall level of indebtedness would suggest.