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May 15, 2026 | 13:29
The Madness of Hiking Galore
Economics
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Fixed Income Strategy
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Economics
The Madness of Hiking GaloreWe believe it would be a major policy mistake for the Bank of Canada to hike interest rates this year. Here’s a top 10 list of reasons why this is not 2022 all over again. |
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Financial markets are currently priced for more than two full rate hikes by the Bank of Canada later this year. Far from pushing back on this pricing, BoC Governor Macklem openly discussed the possibility of “consecutive” rate hikes on April 29 if oil prices stay high and inflation broadens. We are in the business of forecasting what policymakers will do, not what they should do. Despite the aggressive market pricing, it’s pretty clear to us what the should is, and that’s to do nothing. We readily recognize that the Bank was deeply singed by the inflation episode of 2021/22, and does not want history to repeat. But this is not 2022 all over again. Here are 10 reasons why this episode is very different from the inflation flare-up four years ago, when the prior rate-hiking cycle began: 1) Overnight interest rates were near zero in early 2022, pinned at 0.25% since the emergency pandemic cuts in April 2020. Now, the policy rate is a full two points higher at 2.25%, or basically neutral (Chart 1). So, the starting point for policy is very different from that episode. 2) Just prior to the invasion of Ukraine in February 2022, core inflation was already 4% and rising, headed to nearly 6%—its fastest pace since 1991. Now, core inflation is in retreat, with the average of the Bank’s two main measures 2.2% (Chart 1 again). The three-month annualized trend in Q1 slipped to a mere 1.3%; for context, the similar measure was 5.5% in 2022Q1. The key point: underlying inflation was rollicking when oil prices spiked in 2022, whereas it is becalmed now. |
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3) Taking these two elements together, real short-term interest rates were at historic lows in early 2022—hitting a record -4 percentage points that year (overnight rate less average core inflation). Now, real policy rates are essentially zero, right in line with the median since 1995—in other words, perfectly neutral (Chart 2). 4) Speaking of historic, Canada’s job market was likely as strong or tight as it has ever been in the spring of 2022. At one point, the number of vacant jobs poked above 1 million, nearly matching the number of unemployed people. The jobless rate fell to a 50-year low below 5% that summer. We are a long way from those halcyon days, with the unemployment rate pushing up to 6.9%, employment growth basically stalling over the past year, youth unemployment back above 14%, and the ratio of vacant jobs to unemployed people tumbling back to around 0.3, below long-term norms (Chart 3). In other words, the job market is soft overall. |
5) Not unlike the job market, housing was absolutely on fire in early 2022, whereas now it is on ice. Coming at the tail end of a two-year full-on boom in housing during the pandemic, average prices had soared 55% and market measures were historically tight. The sizzling housing market had fanned rental rates and was itself a serious source of inflation. Fast forward to today, and the market remains stuck in the slow lane, with prices down 20% from the peaks and still falling, and market measures holding steady in buyers’ terrain (Chart 4). Suffice it to say that “consecutive” rate hikes would smother an already struggling market, especially at a time of zero population growth. It would fan mortgage delinquencies in Ontario and B.C., and would aggravate the pain for condo builders. Note that the 65 bp rise in five-year bond yields since the start of the conflict with Iran will alone act as a tightening measure, even without the BoC doing a thing. 6) Keeping with the historic shifts theme, Canada’s population growth was gathering steam in 2022, rising 2% that year and on its way to a century high of 3% by 2024. Now, for the first time on record (dating back to Confederation in 1867), Canada’s population has declined in the past year. While there is some debate over the inflationary impact of this shift, there’s no debate that it leads to slower nominal GDP growth, and thus is consistent with lower nominal interest rates. Moreover, our view is that the shift is fundamentally disinflationary, due to the direct impact on rents and home prices. 7) The big slowdown in labour force growth is one reason why job growth has cooled so significantly. But there are plenty of signs that the demand for labour has chilled even more rapidly than the supply. Beyond the rise in the jobless rate from the lows, the total number of hours worked have dropped 0.5% in the past 12 months, a stark reversal from a 4% surge in 2022. That latest reading is not quite recession terrain, but it’s consistent with almost no GDP growth (Chart 5). Note that the Bank of Canada has never tightened interest rates when hours worked were falling on a yearly basis in the past 30 years. (The only episode we can find in the past 50 years when rates were lifted when the economy was struggling so was in 1992, when the Bank was defending the Canadian dollar during constitutional issues. That aggravated a lengthy recession, and was soon followed by very deep rate cuts the following year—i.e., it was a huge policy mistake.) 8) One of the reasons the economy was booming in 2022 was due to the tidal wave of pent-up demand by consumers, following two years of lockdowns. Simply, people wanted to spend again, they were flush with pandemic savings, and price almost didn’t matter. Now, consumers are deeply cautious, many are facing a challenging mortgage rate reset, savings have mostly returned to normal, and there is no urgency to spend. Simply put, the kindling for a big rush of underlying inflation is just not there as it was four years ago. 9) Inflation expectations are not particularly high. Despite the non-stop headlines around rising gasoline prices, both businesses and consumers simply don’t see a big run-up in inflation, reducing the risks of second-round effects from higher oil prices. That’s a very different situation from 2022 (Chart 6). 10) In a similar vein, while supply chain issues have flared due to the Strait of Hormuz closure, it’s simply not in the same league as the post-pandemic issues, which spread around the globe (Chart 7). Moreover, the number and variety of products affected is relatively small. This is not to downplay the impact on some specific goods, such as aluminum and fertilizer, but this episode doesn’t carry quite the same overwhelming risk. 11) Finally, and this list goes to 11, looming over all the proceedings is the USMCA uncertainty, which continues to weigh heavily on Canadian investment plans and growth overall. In early 2022, 81% of firms believed that they would have some or significant difficulty meeting an increase in demand, whereas only 40% do so now—setting a much more muted backdrop for capital spending. Weak investment is a big reason why GDP will struggle to grow even 1% this year, compared with growth of around 5% during the snapback in 2022. Such muted growth will open up more slack, dampening the risk of secondary inflation from the oil shock. |
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Bottom Line: Canada has cooling core inflation, slow economic growth, an ice-cold housing market, and a softening job market, all with deep trade uncertainty overhanging the proceedings. And, yet, the Bank of Canada is considering “consecutive” rate hikes? We appreciate that no one wants to make the same mistake of underestimating inflation for a second time in four years, but we also don’t want to fight the last war—and current conditions are nothing like 2022, other than headline oil prices. We continue to believe that the prudent policy is to keep rates steady in the year ahead, at the very least until there is more certainty on the trade front. If the Bank does, instead, decide to hike rates, it’s fairly certain that it won’t be long before they are coming back down the mountain on the other side with rate cuts. |