Bank of Canada hikes key interest rate by 0.5 percentage points, raising borrowing costs for sixth time in a row

The Bank of Canada increased its benchmark interest rate by 0.5 percentage points, ratcheting up Canadian borrowing costs for the sixth consecutive time this year while warning that economic growth will “stall” in the coming quarters.

This moves the policy rate to 3.75 per cent for the first time since early 2008. Financial markets had been anticipating a larger 0.75 percentage point rate hike.

The central bank said that interest rates will likely need to rise further to get decades-high inflation under control. But it struck a more dovish tone than in previous announcements, noting that higher borrowing costs are already squeezing the economy. It said in an updated economic forecast that there is a roughly 50 per cent chance of a recession in Canada next year.

“We are trying to balance the risks of under-tightening and over-tightening,” Governor Tiff Macklem said in a news conference following the rate decision. “If we don’t do enough, Canadians will continue to endure the hardship of high inflation…If we do too much, we could slow the economy more than needed. And we know that has harmful consequences for people’s ability to service their debts, for their jobs and for their businesses.”

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The decision caught markets by surprise. Mr. Macklem had been notably hawkish in his communications ahead of the announcement, leading bond traders and private-sector economists to expect a larger rate increase. Many thought the bank would move aggressively to keep pace with the U.S. Federal Reserve to prevent further deterioration of the Canadian dollar.

The yield on the 2-year-government bond plunged more than 20 basis points following the announcement. The Canadian dollar fell one cent against the U.S. dollar, hitting 73 US cents.

“In the Bank of Canada’s game of chicken with inflation, central bankers were the first to swerve,” Royce Mendes, head of macro strategy at Desjardins, wrote in a note to clients. “Governing Council still expects that rates will need to rise further, but they are obviously looking to fine-tune policy adjustments more now than they were earlier this year.”

The bank has raised rates six times since March in one of the fastest monetary policy tightening cycles on record. Higher rates make it more expensive for households and businesses to borrow money, with the goal of curbing demand for goods and services and slowing the pace of consumer price growth.

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The effects of tighter monetary policy are “becoming evident” in interest-sensitive areas of the economy, the bank said. The housing market has entered a lengthy slump, while consumer spending and business investment is softening. Canadian exports are also weakening as key trading partners teeter on the brink of recession.

The bank slashed its forecast for Canadian economic growth. It now expects 0.9 per cent annual GDP growth next year, down from its previous estimate of 1.8 per cent. While it avoided using the word “recession,” the bank said that an economic contraction is increasingly likely.

“GDP growth is then projected to slow to be 0 per cent and 0.5 per cent through the end of 2022 and the first half of 2023,” the bank said in its quarterly Monetary Policy Report, published Wednesday. “This suggests that a couple quarters with growth slightly below zero is just as likely as a couple of quarters with small positive growth.”

This puts the bank in a precarious position. Economic activity is slowing quickly, but inflation remains stubbornly above the bank’s 2-per-cent target. Moreover, bank officials believe there is still “substantial excess demand in the Canadian economy,” which is showing up most clearly in labour shortages and rising service prices.

“This tightening phase [of monetary policy] will draw to a close. We are getting closer, but we are not there yet,” Mr. Macklem said.

Headline consumer price index inflation has fallen in recent months, hitting an annual rate of 6.9 per cent in September, down from a high of 8.1 per cent in June. Still, much of the decline so far has come from lower gasoline prices. Other prices continue to push higher, with nearly two-thirds of the components of the consumer price index seeing annual price increases above 5 per cent.

“The Bank’s preferred measures of core inflation are not yet showing meaningful evidence that underlying price pressures are easing. Near-term inflation expectations remain high, increasing the risk that elevated inflation becomes entrenched,” the bank said.

The bank cut its inflation forecast slightly. It now expects CPI inflation to average 6.9 per cent in 2022, down from the previous projection of 7.2 per cent. It sees inflation averaging 4.1 per cent in 2023, down from an earlier forecast of 4.6 per cent, and hitting 2.8 per cent by the fourth quarter of next year.