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Bank of Canada to keep hiking rate despite recession risks

on Oct 25, 2022
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  • Another 75bp rate hike is expected from the Bank of Canada this week
  • Short-term inflation expectations edged down, but still remain elevated
  • Any hint that the terminal rate is near should be hawkish for the Canadian dollar

One of the central banks reporting their monetary policy decisions this week is the Bank of Canada. On Wednesday, the central bank is widely expected to increase the interest rate by another 75bp to 4%.

It is doing so to fight rising inflation.

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Just like in the United States or the Eurozone, inflation in Canada is way higher than the average of the past years. As such, the Bank of Canada was one of the first central banks to react to the rise in the prices of goods and services by lifting the interest rates.

But challenges remain. Inflation in Canada has reached 6.9% and rising, while the interest rate will reach 4% after this week’s expected rate hike.

While the difference between the two is still big, the gap is narrowing. More importantly, if inflation cools down, the Bank of Canada may be in a good position to stop raising rates and watch for further economic developments before deciding on future monetary policy changes.

Concerns mount that the central bank will hike rates before an upcoming recession

The measures taken by central banks and governments to tackle the COVID-19 pandemic have led to an inflationary spiral. Moreover, Russia’s invasion of Ukraine contributed to an energy crisis which further fueled the prices of goods and services worldwide.

Therefore, central banks embarked on a race to tighten financial conditions, knowing there is a lag between rate hikes and the moment they would work their way through the economy. As such, there is always the risk of overdoing it before reaching the so-called terminal rate.

In Canada, inflation is not as elevated as in the United States or the Eurozone. But the aggressiveness of the Bank of Canada in hiking the rates has led to a decline in business sentiment.

Sure enough, the sentiment remains positive, but it is trending down – just as it would before an economic recession. Therefore, the Bank of Canada risks hiking before an economic recession, but it is the only way to fight inflation.

All in all, we may be near the terminal rate, given the fact that short-term inflation expectations have edged down lately. Strong demand and high labor costs are local factors fueling inflation, as well as global factors such as supply chain issues.

Traders should focus on the forward guidance and the language used by the Bank of Canada at this week’s meeting. Any hint that the terminal rate is near should be viewed as hawkish for the Canadian dollar.

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