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Amid "stubbornly-high" inflation – increasing the cost of everything from groceries to electronics – interest rates in Canada are set to go higher and faster than previously expected in a bid to dampen it, says Scotiabank’s Chief Economist Jean-François Perrault.
He joined the Perspectives podcast for a bonus episode to discuss his latest report on the outlook for the next year.
The Bank of Canada is expected to hike rates next week and the policy rate should hit 2% by the end of the year, bumping up the cost of credit for mortgages and other loans.
“Rates are going up much more rapidly than we thought, and probably by a greater extent than anybody appreciates at present,” Perrault said during the podcast.
“We're in the early phases of what we expect to be a pretty serious phase of monetary tightening in Canada.”
Stephen Meurice: I'm Stephen Meurice. And this is Perspectives. You may be wondering why we are appearing in your feed again so soon. Well, we’re recording this on Wednesday, January 19th and this morning, our friend, Jean-François Perrault, Scotiabank’s chief economist, released a report that's a bit of a reality check on inflation and interest rates in the coming year. So, we decided to get JF on the line for a special bonus episode of the podcast and have him to explain what this means for Canadians and for the economy. Let’s get started.
JF, thanks for being here on short notice.
Jean-François Perrault: It’s a pleasure, Steve.
SM: So, you put out this report this morning. What’s the big headline?
JFP: The big headline is interest rates are going up much more rapidly than we thought, and probably by a greater extent than anybody appreciates at present. We're in the early phases of what we expect to be a pretty serious phase of monetary tightening in Canada.”
SM: What are the specifics? What kind of interest rate increases are you forecasting over the coming year?
JFP: So, so the first thing is we think we think interest rates are going to move up next week, so January 26, the first 25 basis point move in Canada. It's followed by another 150 basis points of tightening throughout the year. So, by the end of the year in Canada interest rates are going to be 2%, so the policy rate, the Bank of Canada rate, are currently 25 basis points.
SM: And why is that?
JFP: Well, very simply, inflation is proving to be stubbornly high and, you know, the more inflation information we get, the clearer it becomes that inflation is going to remain higher for a longer period of time than we and the Bank of Canada thought. And then you marry that with, setting aside Omicron for a second, a Canadian economy that's still appears to be in pretty good shape. And, you know, firms complaining of capacity pressures, right? So, we're running up against some kind of limits to growth, beyond which you know the inflationary outlook gets even trickier. So, it's a combination of things, but all rooted, essentially in inflation and inflationary pressures being more elevated than we'd thought.
SM: Just to take a step back. What is the connection between interest rates and inflation? What is it that interest rate increases do that help to fight inflation?
JFP: So, interest rates slow economic growth. So, when you raise the cost of credit and you make it a little bit harder for people to borrow, for firms to invest, and that has a bit of a dampening effect on economic activity. And because inflation is linked to economic activity, as you dampen economic activity, you dampen inflationary pressures. So, it's not a direct link between inflation and interest rates. You've got to go through the economy first, but that that requires changes in interest rates to affect.
SM: So, in spite of the increases that you're forecasting for this year, that will get us from .25% rate to 2% rate by the end of the year, which seems like a big increase over the course of a single year, you're still also forecasting inflation of 4.3% for 2022, which is you know more than you know, substantially more than the Bank of Canada's target rate for inflation. So, why is that? If you're still having significant increases in the interest rate and yet inflation is still going to continue to grow at a pace that's highly unusual over the course of a couple at least a couple of decades, I guess, what are the other factors that are at play?
JFP: Yeah, so the first thing to consider is it takes a long time between when interest rates change and inflation is ultimately affected, right? So, you're talking about an 18- to 24-month period of time. So that's the kind of the delay in the transmission of monetary policy. So, interest rate moves now aren't going to affect inflation very much this year. That being said, you know you have a number of drivers of inflation that are persistent. So, we know that the strength of the global recovery is leading to very significant pressure on input prices, and that is not about to abate. We're expecting strong growth in US strong growth in parts of the world this year, so that driver is still active.
And then you layer in on top of that, things like, you know, the housing market in Canada, which obviously contributes to inflation. We think house prices are going to continue to go up because of the supply issue, not enough homes. You looked at the situation in labour market, where there's been extremely strong job growth in Canada, but that job growth has not kept up with the demand of employers for workers. So, we're looking at, you know, record levels of job vacancies, which we think are going to contribute to inflation pressures over the next 18 to 24 months as well. So, you know elevated international considerations. So, input prices married with some domestic factors which are going to get, I think stronger as year progresses and that gives you a more persistent profile for inflation into 2022 and extending into 2023. If in fact inflation, is, we're right and inflation averages 4.3%, 2022. That is well outside the Bank of Canada’s 1 to 3% inflation control range. So, another reason to amp up the interest rate pressure in the short run, given how far offside inflation is, relative to what the bank wants it to be.
SM: And you've not only forecast a large number of interest rate increases over the coming years, but you think this is the right thing to do.
JFP: For sure, yes. I mean, you know, the threat of inflation is real. And, you know it's only normal that as an economy strengthens that the cost of credit rise with that. You know, this is kind of an equilibrium response in some sense. So, the fact that rates are rising, to us, is completely consistent with the strength of the of the economy and where inflation is. The risk is in our mind is if you don't raise interest rates significantly then you don't control inflation as well and that creates problems for households and eventually businesses, you know, later this year or into next year. So, the benefits of higher interest rates in the current environment are pretty clear to us, even though it comes at a cost. That's how these things work.
SM: Right. There's so many different factors that play where you've got inflation, which everybody is feeling now every time you go to the grocery store, not to mention supply chain issues. And yet we have an economy that's growing at a pretty fast rate. Employment that's high, unemployment that's relatively low, especially given the fact we're still in a pandemic. What's what is a regular person supposed to take from all of this? Are we in a good news situation, are we in a bad news situation?
JFP: I mean so the challenge of inflation and the fact that interest rates are on their way up, the challenge of supply chain issues, the challenge of job vacancies, in a sense is a good problem to have. Because it means that the Canadian economy, the global economy, is recovering very strongly and that's our forecast. As we look at 2022 and 2023, we do expect strong growth and there's a number of reasons for that, but the consequences of that strong growth is you're creating inflationary pressures.
A consequence of that is that you need higher interest rates to control that. A consequence of that is, it’s hard for firms to find workers. So, it's easy to think of the inflation outlook and interest rate outlook as signs of a bad situation. But it's much better to be dealing with that than the opposite, which would be, in some sense, you know, firms aren't spending, households aren’t spending. It's creating additional layoffs; inflation is too low. So, we’re on the flip side of that. We've got too much of a good thing in some sense, which is creating some challenge for households and businesses in terms of managing price pressures and how it impacts their monthly budgets and all those kinds of things.
But this is not a situation that would be occurring if we weren't in the strong economic position that we were in, despite COVID, over the last 12 months or so.
SM: Right, and our wages keeping pace with inflation, and if so, or if they eventually do, does that compound the inflationary pressures that are taking place and push inflation further?
JFP: So, wages are not keeping pace with inflation now, so inflation is well above wage growth, which means that households are seeing a decline in real income. We anticipate that's gonna change as wages increase. So, you're going to have this situation where inflation pressures gradually diminish over the course of the next year, with wages gradually picking up over the course next year, and hopefully we end up in a situation where real wages are not overly negatively affected by inflation. So that's a bit of the flip side of all this, but it's very clear that if wages don't rise, then there is an erosion of purchasing power on the part of households, and that's not a good thing. No question.
SM: And you'd think between inflation and increasing labour shortages, inevitably, that’s gotta drive wages higher.
JFP: Exactly, yes.
SM: So, increasing interest rates over the course of the coming year, what do those look like? How should people be planning to adapt to a higher interest rate environment?
JFP: Well, there's a number of things that folks can do. But clearly, if you have debt, you're going to be paying more for it unless you fixed your mortgage or your debt instrument, at a five-year rate. So, if you’ve got exposure to prime, that's going to cost you more. there's no question about it. I mean, we could be wrong. Our forecasts could be off track, and there could be no rate increases next year or so. But assuming that were right, this is a pretty easy thing to plan around, right? You can figure out if you're comfortable with the type of increase, interest rate increases that we're anticipating. And if you're not, then maybe you want to think about kind of switching your mortgage commitment, your debt commitment around, maybe convert that into a fixed rate product. But same on the fixed rate side. As short-term interest rates go up, so will longer term interest rates. Probably not as much 'cause they've already moved up a fair amount. Every household will have to figure this out on their own, but its pretty safe to say that we should all be planning for a more expensive cost of credit and, you know, figuring out how we as households and companies best manage that.
SM: I’ve been speaking with Jean-François Perrault, he’s the Chief Economist at Scotiabank and kindly joined us today for this quick discussion on his economic forecast for the coming year. Thanks so much for being here Jean-François, always a pleasure.
JFP: Thanks very much, Steve.