The Bank of Canada kept its key policy interest rate at 0.25%, while announcing it will end the quantitative easing (QE) program and that it will move into the reinvestment phase, during which the Bank will purchase Government of Canada bonds to replace maturing bonds.
The Bank continued to provide extraordinary forward guidance as it stated it will hold the policy rate at the effective lower bound until economic slack is absorbed and the 2 percent inflation target is sustainably achieved. The Bank pulled forward when it expected this to occur from the second half of 2022 to the middle quarters of that year.
Along with today’s announcement, the Bank released an updated economic forecast in the Monetary Policy Report (MPR). There were significant revisions to GDP as the 2021 estimate was revised down to 5.1% (July MPR: 6.0%), 2022 was also revised lower to 4.3% (July: 4.6%), but 2023 was moved higher to 3.7% (July: 3.3%). The Bank noted that the downward revisions to this forecast was due to “more severe supply disruptions and weaker foreign demand”. The Bank acknowledged however that there is significant uncertainty around the outlook as the impacts of supply disruptions, labour market mismatches, and accelerated digital investments remain difficult to quantify.
Given negative supply side impacts, the Bank weakened its estimate of potential output growth to 1.6% over 2021-23, which is 0.2 percentage points lower than what it had assumed in the July MPR. Notably, as the downward revision in supply was larger than the drop in GDP at the beginning of the Bank’s projection, the output gap was narrower than what it had previously expected.
On inflation, the Bank continued to expect consumer price index (CPI) inflation to remain elevated through the remainder of 2021 and into 2022, once again due to supply issues as well as higher energy prices. The 2021 forecast was lifted to 3.4% (July: 3.0%), 2022 was revised up to 3.4% (July: 2.4%), and 2023 was a touch higher at 2.3% (July: 2.2%). The MPR stated that inflation was expected to ease to about 2% at the end of 2022 as supply disruptions dissipate, but then rise modestly as economy moves into excess demand territory. The Bank projects inflation to gradually return to target in 2024.
Key Implications
In today’s highly anticipated decision, the Bank of Canada changed up the script. It pulled forward the timing of when it expected the output gap to close to the middle quarters of next year as it judged that supply disruptions were weighing more heavily on the economy’s productive capacity. So, even as the GDP forecast was revised down in this MPR, the output gap closed sooner than what the Bank had projected in July.
In terms of our own view, we expect the Bank will raise rates three times next year, taking the overnight rate to 1% by the end of 2022. Inflation is heating up, and it would be prudent to remove some monetary stimulus as the economy continues down the road to recovery.
That being said, we must acknowledge that there is significant uncertainty around the economic outlook right now. A resurgence of the pandemic could result in greater stimulus, but if there is a faster-than-expected acceleration in household spending, the Bank could raise rates at a faster clip. The Bank of Canada is showing that it is nimble and will react quickly to the evolving economic landscape.
