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Weekly Commentary

That’s a wrap?

December 2, 2022

Royce Mendes
Managing Director and Head of Macro Strategy

There’s no doubt that the Bank of Canada’s aggressive rate-hiking cycle is closer to the end than it is to the beginning. It has to be. The economy simply can’t take much more of this. But whether next week’s rate hike will be the last of the cycle remains a source of vigorous debate. It all depends on the outlook for inflation.

At the moment, headline inflation remains miles above the Bank of Canada’s 2% target and the economy is still overheating. But that’s not enough to conclude that the Bank of Canada needs to raise rates significantly more.

Just this past week, third quarter GDP data revealed that the housing market was once again a significant source of weakness. Economic activity from real estate transactions plummeted during the period. Consumer spending on durable goods, including automobiles and furniture, also continued to pull back in Q3. Those two sectors of the economy are the most exposed to higher interest rates since purchasers tend to employ leverage when buying. For Canadians who own businesses or work in these sectors, this is awful news. But for the Bank of Canada, this is a win. It means that its past rate hikes are working exactly as intended.

Central bankers can’t fix supply chain disruptions, nor can they lower global energy prices. What they can do is cool the domestic economy, primarily through the housing market and household spending. On that front, monetary policymakers can pat themselves on the back. Final domestic demand, a gauge of economic activity within Canada’s borders, showed a contraction for the first time since the lockdowns of 2021. Given the lags in monetary policy, expect further slowing of the Canadian economy next year as a result of rate hikes conducted in 2022. That will help bring supply and demand into more balance.

The question, of course, is whether the Bank of Canada has done enough to bring about the type of balance that would return inflation back to target. The truth is that inflation still has many global components, which means that there are elements that are out of the control of Canadian policymakers. But looking at domestic price pressures, the tide does appear to have turned.

According to a host of metrics, wage growth isn’t an independent source of excess inflation in Canada. That’s in stark contrast to the US, where growth in employee compensation does appear to be feeding consumer price growth. That’s hardly good news for Canadian workers who have seen the purchasing power of their income slashed by high inflation, but it’s another win for a central bank trying to snuff out inflationary pressures.

Measures of what we call “super core inflation,” which try to identify the most recent trend in underlying price pressures, also appear to be falling. According to our calculations, the three-month annualized rates of the Bank of Canada’s trim and median inflation indicators now stand at 3.4% and 3.3%, respectively. That’s well off the highs of around 7.5% from earlier this year and well below similar measures in the US. The deceleration in price pressures is a win for everyone in Canada. It means that even more draconian measures might be avoided. That’s exactly why the Bank of Canada has been moving so aggressively up until now. Central bankers always said that they were unleashing rapid-fire hikes so that they could pause hiking earlier than would have been the case if they had moved slower.

If the Bank of Canada is truly committed to balancing the risks of under- and over-tightening, central bankers would be wise to raise rates only 25 bps next week and move to a more data-dependent stance. We expect the data will deteriorate enough that policymakers won’t hike rates anymore after that. Just don’t expect them to yell, “That’s a wrap!” on December 7. Their risk management approach will leave the door open to further rate increases in 2023 to guard against the possibility that the data doesn’t continue to cooperate. But that’s just central bankers hedging their bets.

Read the full commentary: That’s a wrap?