In a decision that was largely expected by analysts, the Bank of Canada announced an increase in its overnight interest rate to 5.00% today, marking a 0.25% rise from June. This move comes in response to what the bank describes as an "accumulation of evidence" pointing to excess demand and elevated core inflation that are proving more persistent than anticipated. Additionally, the bank's revised outlook for economic activity and inflation played a role in shaping this decision.
While this increase in interest rates was not surprising, it is disconcerting, as the Bank of Canada has also pledged to continue its policy of quantitative tightening. In order to provide you with a better understanding of the bank's current thinking on inflation, interest rates, and the economy, we will highlight their latest observations below:
Inflation Facts and Outlook
In May, Canada's Consumer Price Index (CPI) inflation eased to 3.4%, which represents a substantial drop from its peak of 8.1% last summer. While CPI inflation has been declining as expected this year, the downward momentum has been primarily driven by lower energy prices rather than a significant easing of underlying inflation.
With the removal of the large price increases from last year's data, the near-term downward momentum in CPI inflation is expected to be less pronounced. Moreover, core inflation rates have remained around 3.5% to 4% since September, indicating that underlying price pressures are more persistent than initially anticipated. This outcome is further reinforced by the Bank's business surveys, which have shown that businesses continue to increase their prices more frequently than normal.
Global inflation is currently easing, primarily due to lower energy prices and a decline in goods price inflation. However, persistent inflationary pressures in services persist due to robust demand and tight labor markets.
Canadian Housing and Economic Performance
Canada's economy has displayed stronger-than-expected performance, with increased momentum in demand. Consumption growth, in particular, was surprisingly strong at 5.8% in the first quarter. While the Bank expects consumer spending to slow in response to the cumulative increase in interest rates, recent retail trade and other data suggest that excess demand in the economy remains more persistent.
The housing market has experienced some pickup, with new construction and real estate listings lagging behind demand, leading to added pressure on prices. The labor market has shown signs of increased worker availability, although conditions remain tight, and wage growth has been around 4-5%.
Strong population growth resulting from immigration has contributed to both demand and supply in the economy. Newcomers have helped alleviate the shortage of workers while boosting consumer spending and driving demand for housing.
Global Economic Performance and Outlook
Economic growth has been stronger than expected, especially in the United States, where consumer and business spending have proven surprisingly resilient. In China, however, economic growth is softening, characterized by slowing exports and ongoing weakness in the property sector. Growth in the euro area has effectively stalled, with the service sector continuing to grow while manufacturing contracts.
Global financial conditions have tightened, with bond yields rising in North America and Europe as major central banks signal the need for further interest rate increases to combat inflation. According to the Bank's July Monetary Policy Report, global economic growth is projected to be around 2.8% this year and 2.4% in 2024, followed by 2.7% growth in 2025.
Summary and Outlook
As the impact of higher interest rates continues to permeate the economy, the Bank of Canada expects economic growth to slow, averaging around 1% in the second half of 2023 and the first half of 2024. This translates to projected real GDP growth of 1.8% in 2023 and 1.2% in 2024. The Canadian economy is then expected to enter a period of modest excess supply early next year before growth picks up to 2.4% in 2025.
The Bank's July Monetary Policy Report highlights that CPI inflation is forecasted to hover around 3% over the next year before gradually declining to 2% by mid-2025. This trajectory represents a slower return to the Bank's 2% inflation target than previously projected in January and April. Consequently, the Bank's Governing Council remains concerned that progress toward achieving price stability could stall.
Looking ahead, the Bank will continue to assess the dynamics of core inflation, CPI inflation outlook, inflation expectations, wage growth, and corporate pricing behavior to ensure they align with the objective of achieving the 2% inflation target. The Bank remains steadfast in its commitment to restoring price stability for Canadians.
Stay informed and stay tuned for further updates on economic developments and monetary policy decisions. The next decision for the Bank of Canada is scheduled for September 12th. Stay tuned for another report on that decision.
