With inflation at 3 per cent and the policy rate at 2.25 per cent, real rates are below zero. A quarter-point rise on Oct. 28 is right unless September’s inflation data show oil’s spillover fading.
The Bank of Canada should raise its policy rate by a quarter of a percentage point on Oct. 28, because Canadian inflation has run well ahead of it. The consumer price index rose 3.0 per cent in the year to August, against the 2.25 per cent policy rate the Bank held on Sept. 2. Unless September’s figures show oil’s spillover into other prices fading, that gap is too wide to leave alone.
Oil shocks have a compounding effect on inflation. First, wholesale and retail fuel prices rise. Then, as dearer fuel seeps into other prices, general price inflation sets in. While the Bank can do nothing about the first, as Governor Tiff Macklem said on Sept. 2: “Monetary policy cannot offset the effects of tariffs or influence global energy prices”, the second item is squarely in its business. On the same day of Gov. Macklem's remarks, the Bank’s decision statement warned that “the longer that high oil prices and elevated refinery margins persist, the greater the risk of spillover to the prices of other goods and services.” Prices excluding gasoline rose 2.4 per cent in the year to August, up from 2.2 per cent in July, which is what the second hit looks like.
That acceleration matters because the real interest rate, the quoted rate minus inflation, is already below zero. Subtract August’s headline inflation from the policy rate and the real rate sits around minus 0.75 of a percentage point; against the index excluding gasoline it is about minus 0.15. It is positive, and barely, only against core inflation, the Bank’s gauges that screen out the most volatile prices: CPI-trim was 1.9 per cent in August and CPI-median 2.0 per cent. A negative real rate means borrowers repay less purchasing power than they borrowed, which stimulates spending.
The weaker dollar pushes prices the same way. On Oct. 5, the Loonie was trading at 1.4254 Canadian dollars to one U.S. dollar at the Bank of Canada’s daily rate, the weakest in a year, against 1.3866 on Aug. 31. Reuters attributed the slide mainly to U.S.-dollar strength on French fiscal worries, but the cause makes little difference at the till, since imports priced in U.S. dollars cost Canadians more either way.
The bond market is demanding a hike as well. The yield on five-year Government of Canada bonds was 3.63 per cent on Oct. 5, according to the Bank of Canada, up 0.88 of a percentage point from a year earlier. The Bank’s Sept. 2 decision statement noted that “long-term bond yields have moved up globally, including in Canada,” and the five-year yield rose 0.36 of a point between Aug. 31 and Sept. 29 alone, more than a third of its rise over the year to that date. That yield indicates investors’ guess of where the overnight rate will average over five years, plus extra pay for the risk that the guess, or inflation, turns out wrong, so at 1.38 percentage points above the policy rate it shows that investors expect hikes and want more pay for holding Canadian debt, or both. Economists at Scotiabank, UBS, Manulife and Oxford Economics now expect a hike on Oct. 28, the Financial Post reported.
How the Bank explains its move matters as much as the move itself. Ali Jaffery, KPMG Canada’s chief economist, sees merit in “feeding the beast with one performative hike,” then returning to “wait-and-see mode,” the Financial Post reported. If the Bank is seen to move because yields rose, traders will expect it to move whenever they rise again. The Bank should get ahead of this moral hazard and clearly communicate that an October rate hike is responding to accelerating prices outside core inflation and a negative real rate, not bond market expectations.
A soft services sector argues for stopping after one move, which is why the case here is for a single quarter point. If the bond market is punishing Canada indiscriminately, the punishment still arrives as Canadian inflation, because the dollar’s slide raises the price of every import priced in U.S. dollars, whatever the cause. For those who argue that the Bank's core inflation measure is still below interest rates, and therefore should stay: they need to be reminded that core screens out the volatile prices where a fuel shock shows up first, and will only register spillover once it has embedded broadly. Waiting for core inflation to confirm the spillover means acting after it has happened.
The two wildcards that will influence the Bank's decision are September’s consumer price index and the Labour Force Survey, both releasing before Oct. 28. The case for a hike weakens if the index excluding gasoline falls back to its July level or lower, if core measures stay near 2 per cent, or if unemployment climbs well above the 6.4 per cent the Bank cited in July. The case strengthens if that index rises again or headline (all-items) inflation holds at its August rate. Short of a clear retreat, the Bank should raise its rate a quarter point on Oct. 28 and explain the move by prices outside gasoline and the weaker dollar, so that the next rise in bond yields carries no promise of another hike.
