‘It’s going to get more painful’, Bank of Canada widely expected to raise key interest rate Wednesday

With the economy continuing to show strong growth and a tight labour market despite higher borrowing costs, economists say Canadians should brace for another rate hike this week.

The Bank of Canada is widely forecast to raise its key overnight lending rate Wednesday by another 25 basis points, to five per cent, after surprising markets by restarting rate hikes last month.

“We expect a 25-basis-point hike from the Bank of Canada this week,” said CIBC senior economist Andrew Grantham.

“What we’ve learned from the last rate hike is that (the central bank) would rather err on the side of doing too much to get inflation under control, knowing that they can cut interest rates next year, rather than doing too little in the near term.”

Forecasters say this will likely be the final hike of the cycle, however there is still a risk of additional hikes in the future if necessary to battle stubborn inflation.

“The risks are still tilted to hikes continuing. If the past six months are any indication, we’re just not as interest-rate sensitive of an economy as we thought we were,” said Benjamin Reitzes, BMO’s managing director for Canadian rates and macro strategist.

Last March, the Bank of Canada began an aggressive rate-hike campaign in a bid to drive down inflation, which soared as high as 8.1 per cent. In several steps, the Bank pushed its key overnight rate to 4.75 per cent from 0.25 per cent. After a short-lived pause in interest-rate increases, the central bank’s last hike in June brought the overnight rate to the highest level in 22 years, following a string of economic data suggesting rate hikes weren’t cooling the economy fast enough.

The theory is that by making it more expensive to borrow money, consumers and businesses will spend less, driving prices down and slowing the economy.

Most economists and analysts were not expecting rate hikes this summer amid a looming recession, but labour markets and consumer spending remained surprisingly resilient despite previous rate hikes and rising interest rates. The Bank in June said interest rates must not yet be restrictive enough to sufficiently curb demand, as growth and inflation had both been stronger than expected.

While inflation saw a steep drop to 3.4 per cent in May from 4.4 per cent the previous month, it remains higher than the Bank’s target of two per cent, indicating that the Bank will again raise rates.

“Broadly, the economy has softened, but just not quite as much as (the central bank) wants,” Reitzes said.

“We’re not at a point yet where the Bank can be comfortable that it’s going to drive inflation down to two per cent,” he said. “We’re headed in the right direction, albeit very slowly. And the risks are still that the economy stays more resilient.”

And while the Canadian labour market is showing some signs of softening as the unemployment rate rises and wage growth slows, the economy still added a whopping 60,000 jobs in June, driven by gains in full-time work, Statistics Canada reported Friday.

The Bank of Canada has kept a close eye on the labour market for signs of overheating in the economy. The Bank has repeatedly said that the country’s hot labour market is contributing to high inflation, raising concerns about the pace of wage growth in particular and whether it could prop up inflation over the longer term.

At the same time, the recent uptick in unemployment has been largely driven by rapid immigration, said Jim Stanford, economist and director of think tank Centre for Future Work.

In the first three months of 2023, the country’s population grew by more than 290,000 people, or 0.7 per cent, the highest rate of growth in a first quarter since at least half a century, when comparable data was made available in 1972.

“The June labour market data was mixed but shouldn’t be enough to prevent the Bank of Canada from following through with a second-straight 25-basis-point interest-rate hike at the next policy decision next week,” wrote RBC assistant chief economist Nathan Janzen in a note to clients.

Rising debt
Another rate hike means additional financial burdens for indebted households and mortgage holders, who are being squeezed by rising interest rates, which are increasing the cost of servicing debt.

And many with fixed-rate and variable-rate mortgages who are coming up for renewal in the near future will feel the financial squeeze acutely — according to Statistics Canada’s latest consumer price index released in June, mortgage interest costs rose 29.9 per cent as more Canadians dealt with renewals.

“We’ve already seen about $40 to $50 billion a year in consumer disposable income diverted from buying stuff, to paying more interest to the banks,” Stanford said. “That number is going to get larger and larger in the months ahead as rates go higher and more people are forced to renegotiate their mortgages.”

Consumer delinquencies are rising quickly and in May the Canada Mortgage and Housing Corporation reported that Canadian households have the highest debt-to-GDP ratio of any G7 country. Credit card and car loan delinquencies are also on the rise, a sign that homeowners could eventually begin to default on their mortgages.

“These interest costs are on top of the impact of inflation on real spending power of Canadians,” Stanford said. “Most workers’ wages lagged far behind inflation over the last two years, which means they can’t afford to buy the same stuff they used to.”

“It’s going to get more painful in the months ahead because of the Bank of Canada determination to get back to two per cent (inflation) as quickly as possible.”

Grantham has called on the Bank to be more patient and stop raising rates, which he says might be “unnecessary,” as it is possible that previous hikes are already slowing consumer spending more than the Bank perceives.

Current consumer spending is still lower than pre-pandemic levels, Grantham said, suggesting that “a lot of the growth in consumer spending we’ve seen recently has been a normalization of spending activity and people being able to go to restaurants again, to take vacations again,” rather than “excess demand.”