First National Financial LP

Market Memo: BoC balancing act. Inflation vs Recession – Mar. 2024

  • First National Financial LP

Two years ago, this month, the Bank of Canada launched a fight against inflation and embarked on the most aggressive interest rate hiking cycle in its history.

Between March 2, 2022 and July 12, 2023, the central bank boosted its trend-setting Policy Rate 10 times.  It climbed 475 basis points, from a pandemic induced low of 0.25% to 5.0%. 

Higher for Longer

At its rate setting in March the BoC held at 5.0% for the fifth consecutive time.  The Bank says, underlying inflation pressures remain and high rates need more time to do their work.  BoC Governor Tiff Macklem added that, rates are unlikely to come down as quickly as they went up.

The primary goal of increasing interest rates is to slow the economy and allow supply to catch up to demand.  That has happened.  In the fourth quarter of 2021 Gross Domestic Product GDP increased by 6.7%.  By the fourth quarter of 2023 growth had slowed to 1.0%.

Along with that, inflation has fallen.  The January reading saw the Consumer Price Index, also known as headline inflation, clock-in with an annualized increase of 2.9%.  That is down significantly from the 8.1% posted in June 2022.  Inflation now falls inside the Bank’s target range of 1.0% to 3.0%.

Standing on the edge

By those measures the Bank’s plan appears to be working.  But we have arrived at a time of reckoning. 

Throughout this entire exercise the Bank of Canada’s key concern has been “over tightening”.  That is, pushing up interest rates too fast or too high or for too long and stalling the economy – rather than just slowing it – and sending the country into a recession.

Technically, a recession occurs when there are two consecutive quarters of economic contraction.  So far that has not happened, but we are only about half way through the process.

Rate Hikes Still Being Absorbed

Interest rate adjustments generally take 18 months to 2 years to work their way into the broader economy.  That is where we are now, and just five of the Bank’s 10 increases have been fully absorbed.

By most forecasts, the economy is expected to stave off a recession (or at least a serious recession) chiefly because of population growth fed by immigration.  More people mean more money running through the economy.  But that is a double-edged sword.

Potential Warning Sign

One measure that is troubling in the, otherwise good, outlook is something called “per capita GDP”.  That is, the nation’s gross domestic product divided by the number of people contributing to it.   In Canada, per capita GDP has been dropping for more than a year (six consecutive quarters by some counts) and was down 2.3% in the fourth quarter of 2023, compared to a year earlier.

BoC has some “Wiggle Room”

If the economy does start to falter and drop into recession the Bank of Canada does have to room to start cutting its Policy Rate in an effort to keep things moving.  But as we have seen over the past two years, interest rate policy is a blunt tool for adjusting the economy. And it needs to be remembered that the 18 to 24 month lag-time needed to absorb rate hikes is the same for rate cuts.

For the time being the Bank appears to believe Canada has the economic strength and stability needed to hold the Policy Rate at 5.0% until it gets the strong signals it wants, that show inflation is truly under control.