Canada Ups Inflation Fight Ante With Massive 100bps Rate Hike

After triumphing in a recent battle with COVID, Bank of Canada governor Tiff Macklem will likewise overcome a feverish bout of inflation.

Or at least that’s the message he attempted to convey on Wednesday, when the BoC delivered a 100bps rate hike.

The super-sized move came on the heels of consecutive 50bps increments (figure below).

“Inflation in Canada is higher and more persistent than the Bank expected in its April Monetary Policy Report, and will likely remain around 8% in the next few months,” the July statement said.

Macklem has been accused, hyperbolically, of politicizing monetary policy and serving as an “ATM” for the Trudeau government. Wednesday’s hike suggested the bank is very serious about the inflation fight. And not a moment too soon (figure below).

The statement described a potentially perilous dynamic. “Surveys indicate more consumers and businesses are expecting inflation to be higher for longer, raising the risk that elevated inflation becomes entrenched in price- and wage-setting,” the bank said. “If that occurs, the economic cost of restoring price stability will be higher.”

So, front-loading it is. And aggressive front-loading at that. The loonie jumped, Canadian equities knee-jerked lower and yields rose on Macklem’s surprise move, which was plainly motivated by fears of a wage-price spiral.

The bank spelled it all out in the new MPR. The following excerpt details the nightmare scenario for policymakers:

With inflation high and broadening, inflation expectations have moved upward. These rising inflation expectations are occurring while the labor market is tight and wage growth is strong. This increases the risk that a self-reinforcing wage-price spiral could ensue — a key upside risk to the inflation outlook. In this risk scenario, when inflation remains persistently high, more households and firms base their inflation expectations only on the most recent inflation data. As a result, longer-term inflation expectations become de-anchored and stay above the target. De-anchored inflation expectations lead firms to set prices even higher. Similarly, in response to higher expected inflation, workers bargain for persistently higher wage growth to protect against anticipated losses in purchasing power. The resulting stronger wage growth feeds into production costs and prompts firms to raise prices even further. This process boosts inflation expectations, perpetuating the spiral. The longer inflation remains well above target, the more likely it is that a wage-price spiral will occur. This likelihood also increases if firms have multi-year wage agreements in place with high wage increases in every year.

For all of last year and most of this one, central bankers in rich nations were reluctant to countenance the prospect of a wage-price spiral, preferring to describe such a scenario as unlikely — far-fetched, even.

But with each passing month, it became more clear that the die was cast. In one form or another, to a greater or lesser degree, wages and prices were chasing each other higher in many advanced economies.

The problem (or one problem) is that despite moving up rapidly, wages are struggling to keep pace with inflation. That can precipitate a cost of living crisis, which in turn raises the risk that workers will become more insistent in their wage demands.

The BoC was very explicit about the necessity of short circuiting that dynamic before it’s too late. Policymakers are “keenly aware of the possibility of a wage-price spiral and firmly committed to ensuring [it] does not set in,” the July MPR said, noting that this endeavor “requires setting monetary policy much tighter” than it’d be in a more benign base case.

“While today’s decision was a surprise for markets, we view a 100bps hike as appropriate with the economy in excess demand and inflation running close to 8%,” TD’s Chief Canada Strategist, Andrew Kelvin, said. “Today’s decision leaves policy in the bank’s neutral range, and they are still behind the curve,” he added. TD sees “at least” a 50bps hike in September, but Kelvin did note that policy decisions “will become more difficult into Q4 as higher rates start to bite.”

I’d note two things. First, the BoC’s move raises the odds of a 100bps hike from the Fed later this month, especially in the context of another very vexing inflation report in the US. Second, between Canada, New Zealand and Korea, major central banks (and give me some leeway when it comes to the definition of “major”) delivered 200bps worth of combined tightening in a single day.

Read more: How Long And How Far Will This Go?