Steve Ambler is the David Dodge Scholar in Monetary Policy at the C.D. Howe Institute, and professor of economics at the school of management, University of Quebec at Montreal. Jeremy Kronick is senior policy analyst at the C.D. Howe Institute.
The wait for the Bank of Canada to move is over; now the waiting for the next steps begins.
Wednesday’s rate increase by the bank did not come as a surprise. In its December interest-rate setting announcement, the bank noted that it would be guided by incoming data before raising its target for the overnight rate. Well, the data have spoken. Headline inflation nudged above the bank’s 2-per-cent target in November, coming in at 2.1 per cent, and two of the bank’s preferred measures of core inflation, CPI-trim and CPI-median (which remove volatile components from the index), moved up closer to 2 per cent.
The bank also noted the robust pace of business investment, and the positive outlook for future investment as factors influencing its decision. The labour market was also influential, as job growth for December was particularly strong, with a net gain of almost 79,000 jobs and unemployment falling to 5.7 per cent, its lowest level since 1974.
Markets were therefore expecting the bank to raise the overnight target rate to 125 basis points on Wednesday morning, with a 90-per-cent probability of an increase baked in. Now that it has done that, the key question is how much further, and how fast, the overnight rate will go.
In the December announcement, and again on Wednesday, the bank stated it would continue to be cautious. Markets have been expecting two more 25-basis-point hikes this year. The tone of Wednesday’s announcement puts that in doubt.
Why the hesitation? Partly because of financial stability concerns, which centre on household debt and the fragility of the Canadian housing market.
A more fundamental reason for caution is how slow inflation has been to increase toward the 2-per-cent target.
Since early in 2012, headline inflation has remained under target except for brief periods, and average inflation since 2012 has been 1.5 per cent. This is within the bank’s target range but represents a shift from the two decades from 1996 until the financial crisis of 2007/08, during which inflation averaged almost exactly 2 per cent. Subdued inflation in spite of improving economic conditions and a tightening labour market is not only a Canadian phenomenon: Inflation has also been muted in the United States, the euro zone and elsewhere.
Inflation weakness is a puzzle and the subject of extensive research – including at central banks. It was the subject of a major speech by retired deputy governor Agathe Côté in 2015. One possible explanation is that inflation responds less to slack in the economy, or its absence, precisely because of the success of the bank’s inflation targeting framework, which has led to medium-term inflation expectations that are firmly anchored at 2 per cent.
The persistent undershooting of inflation did not shake the confidence of the market that the bank could return inflation to target in the medium term. That also suggests that inflation will not readily move above 2 per cent. Just as inflation below target was no emergency for the public, investors, or the bank itself, neither should a period of inflation slightly above target be an emergency.
A period of slightly above target inflation can in fact have benefits. First, it will correct for the undershooting of inflation since 2012 and bring average inflation back up toward 2 per cent. This makes future prices more predictable in the long run. Second, it will help convey the idea that the bank’s concerns about inflation are symmetric around the 2-per-cent target. If inflation undershooting persists for too long, it can lead market participants to think that the bank views 2 per cent as a ceiling rather than the midpoint of its target range, and this could eventually lead inflation expectations in a downward direction.
The preponderance of data argued for a rate increase on Wednesday. If the economy continues to speak loud and clear, more rate hikes are likely on the way. However, the bank’s caution is warranted as a result of both domestic and foreign uncertainty. One thing not to fear is a temporary period of inflation above 2 per cent. That would be a nice “problem” to have.