The Bank of Canada ends extraordinary guidance

• The Bank kept the overnight rate at the lower effective bound of 0.25%.
• It is estimated that the economic slack has been absorbed and as such the Bank dropped its extraordinary forward guidance on the policy rate.
• The Bank's new real GDP growth forecast for Canada was revised down to 4.0% (down 0.3 percentage point) for 2022, and 3.5% (down 0.2 percentage point) for 2023.
• Inflation is expected to be markedly higher at 4.2% (up 0.8 percentage point) this year. The outlook for 2023 inflation is unchanged at 2.3%.
• This is a "significant shift" in monetary policy that will change the forecast. The stage is set for policy rate increases. Once monetary policy tightening begins, look for the Bank to reduce the size of its financial balance sheet assets by letting Government of Canada bonds roll off and not be replaced.
• Look for the Bank to tighten monetary policy in March or April at the latest. More interest rate hikes are expected this year to control inflation and bring it back to the 2.00% target.

Previously, the Bank outlined the steps it would take when stimulus was no longer needed. The initial step was announced in October as quantitative easing ended and the Bank moved to the reinvestment phase. The next step, announced today (26 January), was the removal of the extraordinary forward guidance once estimates indicated excess capacity was absorbed. The next step will be the increase in interest rates to control inflation. Supply-side factors such as reduced production, labor absenteeism, and shipping and delivery delays are significantly impacting prices. The Bank is forecasting that inflation will head higher than December's 4.8% year-on-year (y/y) rate going into the first quarter. IHS Markit analysts agree. The Bank of Canada projects that inflation will average 5.1% y/y in the first quarter, but then slow to 3.0% by the fourth quarter. Consumer prices will advance at a more modest 2.2% pace by the end of 2023. The new inflation outlook is driving the significant shift in monetary policy. Previously, the Bank believed that the 2% inflation target would be sustainably achieved by the middle quarters of 2022. The governing council also agreed to signal rate hikes to communicate the Bank's commitment to keep inflation low. This should help lower expectations for near-term inflation, which currently sits above 3%.

Based on this outlook, the Bank's real GDP outlook was revised down. For 2022, the Bank anticipates a bigger subtraction from growth by the housing sector, a smaller positive contribution from the government sector, and a smaller drag from net exports. Inventories will make a larger contribution to growth. Next year, the lower real GDP growth forecast is due to weaker contributions mostly from household consumption, housing, and business fixed investment. Projections for the current quarter show that the absorption of excess capacity and tight labor markets in the fourth quarter of 2021 are expected to be temporarily sidelined with the policy impacts related to the Omicron variant. But the Bank believes that growth will advance in the latter part of the first quarter, resulting in real GDP climbing 2.0% quarter on quarter, annualized (q/q). That is much stronger than the 0.7% q/q in the January IHS Markit forecast. The Bank is more optimistic regarding Omicron's impact on the economy being less severe. Vaccinations are rising, limiting the downside risks associated with the fifth wave.

The latest policy announcement will require changes to the macroeconomic and monetary policy forecast from IHS Markit. The Bank's take on inflationary pressures is not so transitory, as domestic pressures mount beyond just rising housing prices. The Bank estimates that containment measures are having little negative impact on output, relative to potential output. Instead, supply chain disruptions are the primary factor keeping output below potential, at least through the end of this year. Based on analysis by IHS Markit experts, these projections are reasonable and are aligned with expectations.

Posted 03 February 2022 by Arlene Kish, Director, Economics, S&P Global Market Intelligence