Bank of Canada interest rate hike carries risks, economists warn

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The Bank of Canada explained its 100-basis-point hike that surprised observers last week as front loading that historically has raised the chance of a soft landing for the economy.

The theory is that such aggressive action will curb inflation expectations and ultimately limit how much interest rates will have to rise.

But some analysts have their doubts and worry that the landing Canada faces will be harder than the Bank expects.

“A soft landing here is a bit like trying to parallel park a car at 60 miles an hour,” Mark Wiseman, chair of Alberta Investment Management Corp., said on BNN Bloomberg Television. “You have to be not just a skilled driver, but an extremely skilled driver and a little bit lucky.”

Capital Economics’ Stephen Brown says the front-loading argument is based on recent research by the Bank of International Settlements, but notes that “few of the tightening cycles in the BIS dataset featured housing market imbalances as extreme as they are in Canada today.”

And a hard landing for Canada’s housing market looks inevitable, he said.

While the drop in home sales eased in June, the pace of price declines accelerated, said Brown. If the Bank raises its policy rate to 3.5% in October, as Capital expects, the average variable mortgage will rise to 5.3% from 1.3% at the end of 2021.

This would reduce the buying power of the median income household from just above $700,000 to $500,000 — not a lot when the benchmark home price in June was $807,000, he said.

Household disposable income will also be hit hard. “Roughly 40% of households’ $2.7 billion of debt has variable interest rates, implying the 100 bp hike has, overnight, raised interest obligations by 0.7% of income,” wrote Brown.

Though many variable mortgages have capped payments, the steep rise in rates will further deflate already dismal consumer confidence. Bloomberg data before the hike showed that consumer confidence had sunk to levels not seen since the COVID crisis and that points “to a sharp slowdown in consumption growth ahead,” wrote Brown.

The Bank’s latest hike and signals of more to come will bring down economic activity more quickly than expected, say the economists at Desjardins, who now see the odds of recession at 50:50. Canada is especially at risk because of its high level of household indebtedness, they said.

“Given the extremely aggressive rate hike, that more hikes are coming, and the multi-decade highs in inflation, the path to a soft landing for the Canadian economy may not be achievable,” BMO rates strategist Benjamin Reitzes told Bloomberg.

Then there is the question of how high rates will go.

The Bank of Canada’s neutral range is between 2% and 3%, and Governor Tiff Macklem said last week that the policy rate may only need to rise slightly above 3%.

Others say higher. Bank of America strategists see the rate’s climb terminating at 4%, after a 75 bps hike in September, followed by 25 bps raises at each meeting until January.

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