Choose your settings
Choose your language

Sprinting Towards Neutral

April 22, 2022

Jimmy Jean
Vice-President, Chief Economist and Strategist

Yesterday, we released our updated Economic and Financial Outlook titled Central Banks Mount an Assault on High Inflation.We made meaningful adjustments to our Canadian inflation and growth outlooks, lifting both forecasts for 2022 but downgrading them for 2023.

As we’ve been revising inflation forecasts higher in recent months and given that central banks are behind the curve, we have adjusted our views for rates two-fold. First, we believe that we are currently in a shock treatment phase, which will see more supersized hikes and the start of quantitative tightening. In fact, we currently expect the Bank of Canada to deliver a 75 basis-point hike in June.

Second, we believe that policy rates will peak at higher levels than they did in the previous cycle. This means an overnight rate of 2.25% in Canada and a federal funds rate of 3.25% in the US next year. The implication is that we now expect the Fed to lift rates further above neutral than its median forecast has suggested.

While our projection has inflation gradually moderating, it won’t be back below 3% before next year. And there are many reasons to think it might take even longer for inflation to normalize. The first is food, which accounts for 16% of the consumer spending basket. As we discussed in a recent Weekly Commentary,food prices are one of the main ways the war in Ukraine is affecting the rest of the world. This week's inflation report showed that Canadian grocery prices are up 8.7% year over year, the fastest pace since 2009. And it's safe to assume they'll continue to rise as the impact of developments in Ukraine makes its way through the food processing chain.

The second reason is supply chains. We hoped to start seeing them gradually improve this year. Instead we got the Ukraine war and new lockdowns in China. Meanwhile the semiconductor shortage is nowhere near being solved, and car dealer lots remain thinly stocked. Hiking rates more forcefully won't fix these issues directly, but it will address one of their root causes: strong demand.

Psychology is the third reason. Given what's driving inflation, the current policy normalization campaign is partly an exercise in persuasion. Even if long-term inflation expectations remain anchored, households and businesses could eventually lose faith in central banks’ ability to curb rising prices. We expect that Canadian inflation will have overshot the BoC’s target range for nearly two years. We're already seeing a change in behaviour, with companies feeling more emboldened to pass along higher costs without worrying about losing market share. That’s a marked shift in mindset from the previous cycle. The longer inflation is out of control, the more this behaviour becomes entrenched.

Meanwhile, with workers being in short supply, they’ll have a strong incentive to protect their purchasing power. This doesn’t necessarily mean strikes. It can be things like switching to a higher-paying job, asking to work less for the same pay, or turning down a job that doesn’t pay enough. Price and wage expectations ultimately guide these behaviours. That’s why central banks are now in such a rush. They want to keep those expectations in check. To do that, they'll have to tighten more than they did in the last cycle. Doing so, central banks could end up shortening the expansion cycle. But they seem willing to live with that risk.

Read the full commentary: Sprinting Towards Neutral