Have interest rates peaked at 4.5 per cent? Here are three reasons they might increase next month

After eight consecutive hikes, the Bank of Canada decided to take a pause this month and kept its key rate unchanged at 4.5 per cent, its highest level since July 2007. Year-on-year inflation since peaking at 8.1 per cent in June last year.

Despite this, the bank appears unwilling to commit to ending the tightening cycle. “This is a conditional stay,” said senior deputy governor Carolyn Rogers. More precisely, a conditional pause on inflation falling in line with the bank’s forecast of three percent by mid-year and two percent by 2024.

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Despite the economy’s high resilience and labor markets remaining tight, many economists and financiers believe the bank will keep the policy rate unchanged in its next announcement on April 12. The idea has become even more prevalent after the Silicon Valley Bank failure, which raised financial stability concerns above price stability concerns.

However, I am among the shrinking minority who think otherwise. While the situation remains very volatile, I believe the Bank of Canada’s credibility is at stake, and thus the bank will feel compelled to raise its policy rate – most likely by 25 basis points – next month. I can think of three main reasons for a bank to do this.

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First, this month’s pause made the Bank of Canada the first major central bank to stop raising interest rates – thus putting the bank on a different trajectory relative to the US Federal Reserve and other central banks. This puts downward pressure on the value of the loan, thus fueling inflation by raising the price of most imported goods.

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In fact, the Canadian dollar has already devalued by about three percent with respect to the US dollar since the beginning of February, and slightly less with respect to the euro and the British pound. Therefore, keeping the Bank’s key rate unchanged while other central banks can continue their increases will accelerate inflation – which the Bank is determined to contain.

So, yes, the bank may raise the policy rate next month.

Second, while year-on-year inflation was 6.3 per cent in December, the data show that prices rose very sharply till June and not so sharply thereafter. In fact, average prices rose at an annual rate of about 13 percent in the first half of 2022, and three components of the CPI basket — food, shelter and gasoline — accounted for 75 percent of this price increase. Specifically, the price of gasoline increased by 48 percent and accounted for 40 percent of total inflation in those six months.

The situation was quite different in the second half of 2022: The price index remained virtually unchanged – in fact, it grew at an annual rate of just 0.3 percent – ​​offset by a 30 percent decrease in the price of gasoline due to price increases in both food and shelter.

Will this pattern continue? Most likely not, I’d say.

Indeed, it seems unreasonable to expect that inflation will continue to decline because of a significant reduction in the price of gasoline or any other component of the CPI basket. Instead, it is most likely that headline inflation will continue its downward path as a result of the deflationary process, that is, due to lower rates of increase in prices of most components of the CPI basket – without significant reduction in prices of any of them. More precisely, the expected future decline in inflation may not be based on expectations of a continued decline in gasoline prices.

And that’s what the January figures show. Although year-over-year inflation fell to 5.9 in January, on a month-over-month basis the price index rose at a sharp annual rate of 6.5 percent — mostly due to price increases in food and gasoline. In fact, excluding food and energy, average prices only rose at a moderate annual rate of 2.5 percent.

In my view, 2.5 per cent should be seen as an acceptable rate of inflation which should not require any bank intervention in the form of increase in interest rates. However, the bank seems confident that the current inflation is a result of excess demand, which in their view can be rectified by an interest rate hike.

So, yes, the bank may raise the policy rate next month.

A third reason is that the labor market is still very tight: In January, the unemployment rate hovered near its historic low of 5.0 percent, and wages rose 5.4 percent from a year ago’s level. And that’s what worries the Bank of Canada most: the tight labor market is “one of the signs the economy is heating up,” said Tiff McCallum, the bank’s governor.

Therefore, unemployment should increase in order to reduce wage demand and prevent a hypothetical wage-price spiral – despite the fact that inflation is still higher than the rate of wage growth, so wages certainly do not lead to inflation. Has been But McCallum believes that “running wage growth in the four to five percent range … is not consistent with getting inflation back to our two-percent target.”

So, yes, the bank may raise the policy rate next month.

As I indicated in a previous article, the economy is doing pretty well – and that should be a cause for celebration, not worry. In fact, unemployment is low, inflation is falling, and real wages are improving. Therefore, the Bank of Canada should not increase the rate of interest further.

Fortunately, the rapid increase in interest rates from March 2022 has not yet pushed the economy into recession – but neither has it helped in reducing inflation. Indeed, since June inflation has eased due to a reversal of the same externalities that pushed it up in the first place.

Interest rate increases have only contributed to increasing the likelihood of a financial crisis, and going forward will most likely result in a financial and economic crisis – something the Bank of Canada should be trying to prevent, not cause.

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