BANK OF CANADA STARTED TAPERING AND INTEREST RATE HIKE LIKELY IN 2022 1ST QTR
The Canadian government is spending C$101 billion ($81 billion), about 5% of GDP, to stimulate the economy over three years. With fiscal spending booming and households flush with cash, investors are betting that the Bank of Canada’s next tightening cycle, expected to begin in 2022, will result in interest rates climbing above the previous peak for the first time in decades.
BOC has already begun to taper secondary-market bond purchases. U.S. and Canadian fiscal stimuli, labor market recovery, and public efforts to vaccinate adults fully by September resulted rating agencies’ upward revision of 2021 GDP growth to 6.6% for 2021 despite second and third COVID-19 waves, expected GDP growth of 3.5% in 2022 and 2.4% in 2023. Large base effects, economic momentum, and supply shocks triggered an inflation uptick to 3.6% YOY in May, although inflation expectations remain well-anchored. The current account deficit/GDP is projected to remain moderate, returning to above 2% during 2021-2023 (consistent with 2017-2019) after it narrowed to 1.8% in 2020 as a lower travel services deficit more than offset the effect of the wider trade deficit. However, FDI remains a net outflow and will contribute to net external borrowing/GDP near 3% of GDP during 2021-2023.
A higher endpoint for rate hikes could give the BoC more firepower to fight the next downturn. It could also spur changes to the economy, raising the incentive to save and invest rather than borrow. Canadians have borrowed heavily in recent years to participate in one of the world’s hottest housing markets.
In four major tightening cycles since the early 1990s, the Bank of Canada’s key interest rate has peaked at a level that was lower than the preceding endpoint. But that could change in the next cycle, as historic levels of government spending globally raise prospects of an economic recovery from the COVID-19 crisis that is more robust than previous recoveries.
Canada’s central bank has signaled that it could begin raising rates from a record low of 0.25% in the second half of next year, well ahead of the 2023 projection from the Federal Reserve.
Swap market data puts the peak of the expected tightening cycle, or the terminal rate, at about 2% in five years, above the previous peak of 1.75%.The neutral rate is the level that is expected to be in place when the economy is at full strength and inflation is on target, so it’s a signpost of sorts for where rates could go. The BoC’s current estimate for the neutral rate is a range of 1.75% to 2.75%.
The central bank has also estimated that Ottawa’s support for households during the pandemic combined with reduced spending by Canadians, who endured lengthy lockdowns, boosted savings in 2020 by about C$180 billion. That extra cash is likely to add to consumer spending over the coming decade, which could support a terminal rate that is higher than not only the previous cycle peak but the neutral rate.
