By Michael O’Neill

The Bank of Canada is betting that it can effectively and efficiently manage inflation. They believe that the Consumer Price Index, which soared to 6.7% y/y in March, will recede to 2.5% y/y in just eighteen months. If they are wrong, Canadians won’t be going for broke, they will be broke.

The case for betting against the BoC effectively managing inflation to the 2.5% level is pretty good. That’s because the current bout of inflation pressures is not domestic but due to global developments far beyond the BoC’s influence.

Soaring oil prices are a major driver of higher inflation. West Texas Intermediate (WTI) suffered a Covid-fueled, technical plunge that drove cash prices to negative $38.00/barrel two years ago. They traded at $102.50/barrel on April 20, 2022.

Statistics Canada reports inflation with and without energy prices because of the volatility of crude prices.

Oil prices are not expected to decline any time soon. The sanctions imposed on Russia following the invasion of Ukraine will not disappear if and when hostilities end. Chinese demand for crude is expected to rebound quickly as Covid-19 lockdown measures ease and in the wake of new fiscal stimulus.

The US Energy Information Administration (EIA) expects WTI prices to average $112.00/b in Q2 2022, while Goldman Sachs analysts predict $135.00 in 2022.

The Bank of Canada does not influence crude prices which means it cannot do anything about the inflationary impact of higher prices.

The March inflation report noted substantial price increases for furniture (8.2% m/m) and new vehicle prices (1.6% m/m). These increases are due to ongoing supply-change issues, Covid-related port disruptions, and higher transportation costs.

All the above are external issues and beyond the BoC’s ability to influence.

March CPI also noted an 8.7% jump in food prices, attributed to increased wholesale and transportation costs. Justin Trudeau’s government added to the inflation woes by allowing the Canadian Dairy Commission to hike prices for butter (16.0%, cheese (10.4%), and fresh milk (7.7%.).

External pressures may be playing an out-sized role in driving Canadian inflation higher, but it is still the BoC’s problem to fix.

Bank of Canada Governor Tiff Macklem accepted the challenge. In his opening statement for the Monetary Policy Report  (MPR) press conference he said “Inflation is too high. It is higher than we expected, and it’s going to be elevated for longer than we previously thought.”

But he has a plan, and that plan includes sharply higher interest rates. Mr Macklem claims that “By making borrowing more expensive and increasing the return on saving, a higher policy interest rate dampens spending, reducing overall demand in the economy. And with demand starting to run ahead of the economy’s supply capacity, we need that to happen to bring the economy into balance and cool domestic inflation.”

The 6.7% y/y spike in domestic inflation is a call to action.

The BoC believes the neutral interest rate (defined as the level that neither stimulates nor weighs on the economy) is in the 2.0-3.0% area. The current overnight rate is 1.0%.

That suggests rate increases are coming down the pipe and economists from Bank of Montreal and JP Morgan predict 0.50% rate hikes at the next two monetary policy meetings with the risk of another 1.0% bump by year-end.

Will it be enough to slay the inflation dragon?

Picture: Game of Thrones/HBO

Probably not.

Raising Canadian interest rates to 3.0% is just a 1.25% bump from the pre-pandemic level. The increase will not do anything to alleviate supply chain concerns exacerbated by the Russian hostilities, will not increase oil production, or even put a damper on spending.

Interest rates will have to rise far higher than the top of the BoC’s neutral rate range. That’s because rates are starting from a historical low. The BoC overnight rate has remained in a 0.5%-1.75% band since May 2010. Rates were 4.6% in 2007, just before the Financial Crisis but averaged 3.8% from 2000.

To borrowers who remember the late 1970s, and early 1980’s, interest rates since 2000 are a bargain. Millennials looking at 4.6% rates would shout “usurious” after they googled the word. 😊

Sure, it’s a matter of perspective, and things are different this time. But are they?

Remember the 1980’s?

Source: BoC

Soaring oil prices fueled the inflationary spiral in the early 1980s, and they are doing it again today.

Oil price increases are exacerbating a fractured supply chain in a world still emerging from the COVID-19 pandemic.

In addition, the global fall-out from the Russian invasion of Ukraine, ongoing trade frictions between the US and China, North Korea’s nuclear ambitions, and the never-ending hostilities in the Middle East are inflationary IED’s. 

An aggressive series of rate hikes may drive inflation lower over time, but the hikes also risk driving the economy into a recession.

The BoC is going all-in.”  Interest rates are the chips, the players are dodgy, and Recession may be the big winner.