The Bank of Canada hiked interest rates once again, but this time by a half percentage point to 1%.

This marks the first time in more than 20 years that the country’s central bank increased the key policy rate by that much in a single move.

What does this large interest rate hike mean for Canadians going forward?

Scotiabank’s Chief Economist Jean-François Perrault and Scotia Wealth Management's Chief Investment Officer Andy Nasr return to the Perspectives podcast to discuss the impact on the outlook for the economy and markets.

Click here for the transcript.

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Transcript:

Stephen Meurice: The Bank of Canada hiked interest rates again yesterday. This time by half a percentage point. The move was expected. But it's the first time in over 20 years that the Bank has increased its policy rate by that much in a single shot.

So, what exactly does that mean for Canadians? Will this help stop the inflation that's seen the price of just about everything go up dramatically? What's the impact on our investments? To break it down for us we're joined by Scotiabank’s Chief Economist Jean-François Perrault as well as Andy Nasr, Chief Investment Officer at Scotia Wealth Management. Let's get started.

JF, Andy—welcome back to Perspectives.

Jean-François Perrault: Thanks Steve.

Andy Nasr: Thanks for having us.

SM: JF, let's start with you. So, we're recording this less than an hour after the Bank of Canada made its latest rate announcement. Can you sum up what happened this morning? What did they say? 

JFP: Well, very simply, they raised interest rates by 50 basis points which was roughly in line with market expectations. It's something we've been forecasting for quite a while and they did that on the basis of an inflation outlook, which is very troubling from their perspective. They raised the inflation forecast a lot. Still expecting very strong economic growth. But with that obviously the concerns about inflation, the concerns about what it means for Canadians has led them to say that they needed to higher interest rates right now, but also very clearly indicate that they are going to be raising interest rates quite a bit more as we go forward without being very specific about what that means. Very clearly signaling that they are nowhere near done raising interest rates. 

SM: Right. So, the point of raising the interest rates is to try and tackle the problem of inflation. Everybody is aware of prices going up across the board on just about anything you buy, what are they projecting in terms of inflation? And what does that mean for people over the next six months, a year? What's the bank saying about inflation over the coming period? 

JFP: So, they're saying that for the first half of the year inflation will be around 6% which is obviously well above their 2% target and then inflation will gradually decline to closer to their target sometime in 2024. So, an elevated inflation environment for quite a while. And you know, that's a challenge for Canadians. It's a challenge for obviously the central Bank because they've got to manage that. It basically indicates that we as consumers and businesses are going to be dealing with elevated price pressures for a significant amount of time. So, as they raise interest rates, I mean obviously a consideration there is they want to slow economic activity to try and reduce these inflationary pressures and they were very clear about that. But, they're also very clear that they are worried about inflation expectations. So, they don't like that Canadians expect inflation to be above 2% this year and next. And part of the reason for their actions now is to try and ensure that Canadians kind of believe a little bit more firmly that inflation is going to come down to 2 at some point in time. 

SM: So, managing those expectations is important because if people expect prices are going to keep going up across the board, that changes their behavior, it changes the way businesses behave and all of that. Is that right?

JFP: Exactly. That's exactly it. 

SM: Okay. Andy, I will get to you in just a second. I just have a couple more questions for JF here. Are you able to give sort of the 60 second explanation about how does increasing interest rates lower inflation? 

JFP: Basically, when you raise interest rates you make it more expensive to borrow. And in so doing you reduce investment, you reduce consumer spending and that reduction in economic activity takes some of the pressure off the economy and generates a bit of a lower inflation outlook than otherwise would be the case. So, it's really a mechanism through which economic growth slows. And that eventually impacts inflation. But that takes a while, that's you know, anywhere between 18 and 24 months. So, the interest rate increase that they did today is not going to impact inflation next six months. This is really about managing inflation over kind of the next 2 year horizon. 

SM: Right. Because if it's slowing down economic activity, they obviously also don't want to slow it down too much. I mean they want the economy to keep ticking along and people to have jobs and all of that.

JFP: Absolutely. This is a fine-tuning process. There's no question about it. So, they will be you know, reasonably aggressive but still pretty gradual because they need to just kind of see in real time if the move in interest rates that they are engineering is you know, having outsized or unintended consequences on the outlook. So, they're gonna be very, very watchful for that. They always are.

SM: Okay. Andy, let's turn things over to you now. How are markets reacting to today's news? Or given that this was somewhat expected, had the market's already factored that in? 

AN: Yeah. I mean I think investors had expected central Banks in Canada in the US to hike policy rates quite substantially throughout the remainder of the calendar year and even into next year. So, to some extent this wasn't unexpected. But the impact that it has on markets is going to vary depending on the asset class. Equities tend to perform a little bit better than fixed income securities during periods of rising interest rates. But the rates of return are largely influenced by the pace of policy rate increases and the health of the underlying economy. So, if the supply shocks that we're experiencing translate into persistent price pressures and wages continue to rise then as Jean-François pointed out, a lot of companies are going to have a harder time maintaining their margins and growth estimates may have to be tweaked a little bit. Which could muddy the outlook and cause a little bit of volatility.

SM: Right. You said increasing rates affect different asset classes differently. Are there some general principles around that that you could explain, or really does it vary very much even from sector to sector? Or how complicated is this?

AN: If you think of the two major asset classes and that's maybe where we'll focus. Equity returns tend to be strongly correlated with corporate profits. So, if the company that you're invested in makes more money, you should make more money. Corporate profit growth is a little bit more difficult when you have cost push inflation. So, if your input costs are rising or the cost of wages are increasing, companies are going to have to figure out how to pass those higher prices through to their end markets. Whether their end markets are corporations, other corporations or households. So, if you're a really good company and you've got defensible business model, you got some pricing power, chances are you're gonna be able to make your way through this just fine. Even though investors might start to speculate about what that means for the next quarter, a couple of quarters. From a medium to long term point of view, everything should be okay and inflation typically provided that it's not, you know, mid-single digit or high single digit inflation doesn't typically spell the end of days for corporate profitability. Fixed income securities, you end up getting a pretty stable return when you invest in those, you're either lending money to a corporation or a government. But it's a fixed nominal return. And you know, if you do have high inflation, obviously that tends to erode your purchasing power. If you're invested in instruments that give you a 3% yield or 4% yield and all of a sudden rates overshoot then you tend to see investors kind of eschew those kinds of investments in favour of other things or end up holding cash. So, you start to see differences between the relative rates of return in asset classes and the expected return in asset classes. It's those gyrations that ultimately create a little bit of volatility. And that's why investors should, you know, for the most part try to be pretty well diversified so they can opportunistically take advantage of asset classes that pull back the most and give them the best risk adjusted returns.

SM: I was just going to ask you, what is your guidance for people during both an inflationary period, a period of rising interest rates, a period of geopolitical uncertainty. How do you balance those factors when you're providing guidance to your customers?

AN: Well, there's always things to be worried about when you're an investor. [Laughs] Seemingly there's a lot more these days than there has been for the last year or so. You know, in our view right now, diversification does make the most sense because it helps mute overall portfolio volatility, it's not unreasonable to assume that markets become a little bit choppier. If you're reading the headlines, there's some concerns about yield curve inversion. That occurs when short term interest rates are higher than long term interest rates. And yield curve inversion can signal recession. But most investors forget that equity markets typically appreciate by 20% several quarters after inversion occurs and based on the way that we defined it, we're not there yet. So, there should still be some upside provided that you've got a portfolio that's anchored to high quality investments. The challenge is going to be, you know, remaining patient and not trying to time the market, which is, you know, the single biggest mistake that investors typically make. 

SM: So, then what is your outlook for the next six months or so?

AN: Six months? Huh? [Laughs] That's an awfully short timeframe. You know, it's much easier to figure out where things are going from a long-term perspective, but I'll echo Jean-François’ point of view. Which is, you know, even though there's some talk of a global recession, it's not likely that's going to be part of the base case scenario in 2022. So, in that context, you know, we think that investors are going to get an opportunity to make some changes in their portfolio that hopefully allow them to meet their long-term objectives. Within the next six months, you could see more volatility. You know, if the growth estimates need to be recalibrated or tweaked, investors will always assume the worst, kind of ask questions later. So that's typically what creates a separation between, you know, fundamentals and that long term point of view versus sentiment, which can become overly negative and too focused on headlines in a short time frame. So, I think that's what we always have to keep our eye on is just those opportunities that are created by a significant decline in risk inclination and that could definitely occur within the next six months.

SM: Okay, JF, I'm gonna turn back to you. The cost of housing has obviously been in the news a lot for, well through the entire pandemic, if not before. What impact will these higher rates continuing to rise over the next year or so, what impact will they have on the housing market?

JFP: Well, clearly, when you raise the cost of mortgages, people are able to afford less. I mean, the general idea behind raising interest rates from the Bank of Canada’s perspective is going back to earlier, is to raise the cost of financing to encourage a bit of a slowdown in spending. And of course,  housing is a very, very important part of that. It is the single biggest liability that households typically have. So therefore that tends to be the area where interest rates have the most impact. So, we do think this is going to be slowing demand for homes. It should lead to a moderation of price growth. But it doesn't do anything about this big gap that exists right now between the fundamental demand — so, like the number of people in Canada versus the number of homes in Canada. So while interests are gonna help rebalance markets a little bit, I don't think this is an environment where we're going to see very significant correction in house prices, more of a slowdown in the pace of growth and maybe even kind of flat growth for a little while. That actually would be a pretty positive outcome given where house prices are in the country.

SM: So just one final thing. You've made your projections in the past about where interest rates will end up by the end of 2022. Sticking to those projections or is it even higher than maybe you anticipated? Where are you at?

JFP: We're pretty comfortable. I mean, the Bank of Canada's outlook basically echoed our own. I mean it looks like it's a little bit of a copy paste from our forecast to their forecast. So, we're happy with where things are. And that means if we're right, that the Bank of Canada policy rate will go to two and a half by the end of the year and to 3 by early next year. 

SM: All right. Andy, any parting words of solace or guidance for people out there looking at all this exciting economic news going on.

AN: It's a lot to digest. There's going to be a lot of concerns in the headlines. A lot of fearmongering, but perspective helps. It's the name of the podcast.

[all laugh]

SM: Well, we'll leave it there. Andy, JF — thank you both once again for lending us your insights. We really appreciate you coming.

AN: My pleasure, Stephen.

JFP: You’re very welcome.

SM: I've been speaking with Andy Nasr, Chief Investment Officer at Scotia Wealth Management and Jean-François Perrault, Chief Economist at Scotiabank.