With inflation surging, the Bank of Canada has embarked on a new program of policy normalization. At its last policy meeting, the central bank raised its interest rate by half a percentage point, to 1 per cent, and signalled that it would soon start to reduce its balance sheet, a process known as quantitative tightening.
The moves, which were widely expected, are part of a general move around the world - including Canada - to tighter financial conditions. Two broad factors are behind the Bank of Canada's change in policy:
- Global events are adding pressure. First, global events, including the war in Ukraine and COVID-19 outbreaks in China that have led to lockdowns, add pressure to global supply chains and drive the inflation outlook higher. In particular, the war in Ukraine and the energy shock it has prompted added 0.7 per cent by itself to the Bank of Canada's inflation outlook.
- The Canadian economy is overheated. Consumer demand remains strong despite price increases, and the unemployment rate is the lowest in nearly half a century. By increasing interest rates, the central bank will make borrowing more expensive, which in turn will cool the economy, including the housing market.
Beyond raising interest rates, the Bank of Canada has to contend with a ballooning balance sheet, which increased almost five-fold since the pandemic began, compared with a 114 per cent increase for the Federal Reserve.
Now, with quantitative tightening on the horizon, the bank said it would stop replacing maturing securities on its balance sheet, allowing expiring assets to roll off and reducing the overall size. An outright selling off of assets in the near future would not be surprising.
Nonetheless, monetary policies take time to work through the market, so one should not expect magic. Inflation will remain around 6 per cent in the coming months before the effects of rising interest rates are felt.
Amid the uncertainty, the Canadian economy is well positioned to grow this year given its competitive advantages in the commodities and energy sectors. For this reason, a rate hike is a given in the Bank of Canada's next announcement in June, and a 50 basis-point increase would not be out of the question.
The deterioration in financial conditions
Central banks now recognize that monetary policy is transmitted to the economy through financial conditions. The Bank of Canada noted in its April statement that global financial conditions have been tightening, a result of a universal switch to policy-hike regimes among developed economies in recent months.
The interest-rate markets were already anticipating this response by the central banks to the worldwide surge in inflation, which is occurring in an era of product shortages and a surge in demand during the recovery from the pandemic. Add to that Russia's invasion of Ukraine, and perceptions of inflation are almost certain to rise.
The RSM Canada Financial Conditions Index is a composite measure of financial accommodation or risk priced into financial assets in the commodity, equity, money and bond markets.
Positive values of the index denote an environment of stability and reduced risk necessary for investment and economic growth. Negative values of the index denote instability, increased levels of risk, higher costs of investment and the prospect of slower economic growth in upcoming quarters.
Our composite index stands at minus-0.2 standard deviations below financial conditions than would normally be expected. Excluding the commodity markets - which have benefited from the outsized price increases in petroleum products and food because of the war - financial conditions are 0.7 standard deviations below normal.
These values suggest a drag on the economy in the coming quarters as the propensity to borrow or lend declines.