Perspectives podcast: Cycle of interest rate hikes begins

The Bank of Canada has hiked interest rates, after holding off in January. Scotiabank’s Chief Economist Jean-François Perrault explains why rates are rising now, how Ukraine factors in, and why this hike won’t make a dent in inflation - yet.

Click here for the transcript.

Transcript:

Stephen Meurice: I'm Stephen Meurice and this is Perspectives.

Well, today the Bank of Canada has finally done what most economists expected, raised its key interest rate by a quarter percentage point. So, we're bringing back Scotiabank's Chief Economist, Jean-François Perrault to explain what an interest rate hike means for Canadians and the economy. Let's get started.

JF, Thanks as always for coming on the show. This is your third time in about a month. So, congratulations on the hat trick.

Jean-François Perrault: [laughs] Well, thank you.

SM: So, we're recording this on the morning of March 2^nd. Just a couple of hours out from the Bank of Canada's announcement, let's talk first about the context for this. There's the Russian invasion of Ukraine of course. But also, inflation higher than it's been in around 30 years. There are good GDP numbers that came out this week. There are high oil prices, may be bad news at the pumps, but can be good news for an oil producing country like Canada.

How do you think the Bank of Canada weighed all those factors to arrive at the decision that they announced today?

JFP: Well, listen, the factors that you've indicated, Steve are all I think reasonably scary for the Bank of Canada in the sense that they all pushed inflation further away from where they wanted to be. You know, we had strong growth in the fourth quarter, stronger than we had anticipated. Stronger than the bank Canada anticipated. Indications for January growth are that it was stronger than we thought as well. Inflation principally coming in higher. Obviously, the situation in Ukraine is a huge geopolitical issue and it is creating uncertainty and it's creating financial market volatility, but it's also leading to significantly higher commodity prices. Oil in particular. Now that benefits us, but it also creates a lot more inflation. So, all those things just have to be prompting the Bank of Canada to think that inflation is going to be higher than what they earlier thought.

SM: I would have thought that sort of a geopolitical crisis, like what's going on in Ukraine, as you said, it causes uncertainty and market volatility and so on and potentially can slow global economic growth. Yet, as you say, it also pushes up commodity prices. So, do those factors then kind of cancel each other out or is what's going on in Ukraine more of an inflation risk than it is a global economic slowdown risk?

JFP: Yeah, there's a couple of things to keep in mind there and not all countries react the same way to what's happening in Ukraine, right, for countries that are importers of commodities, obviously this is very negative for them, right? Because they're paying more for commodities and there's this global uncertainty impact. And if you're closer to Russia and trading with Russia then obviously you've got the trade impact. Canada's sufficiently far away from the conflict itself and we are sufficiently large producer of commodities that for us, the equation is a little bit different. The impact of the rising commodity prices might outweigh the impact of uncertainty and other kind of trade related issues that are flowing out of Ukraine. So, for sure, global growth is going to be weaker because of this, but that doesn't mean necessarily that Canadian growth is going to be weaker as a result.

SM: Okay, so the purpose of the rate increase obviously is to try and tackle inflation, which consumers are seeing everywhere from the grocery store to the gas pump. What impact will the increase have on rising prices? When do you think people can expect to get some relief?

JFP: That's going to take a while. So, this is the first increase that the bank Canada's done. We think significantly more rate increases are to come. But it takes a long time between when interest rates rise and for there to ultimately be an impact on inflation. Right? Something like 18-24 months. So, this is obviously the beginning of the cycle. Over time it will have an impact on controlling inflation, dampening inflation. But for the time being, inflation is somewhat on autopilot, right? We’re hostage to previous decisions, we’re hostage to global developments. And those all indicate that in the short run, inflation is probably going to go higher rather than lower.

SM: Okay, so at least no short term relief on that front. What are the economic impacts or the pocketbook impacts of the rate increase? You know, inflation is hitting people on one side, some people I guess are going to get hit by the rate increase as well. What's the impact on consumers of the increase?

JFP: So obviously, when the bank of Canada's raising interest rates, it's trying to do that to slow the pace of economic expansion and by slowing the pace of economic expansion—or when they try to slow the pace of economic expansion that's occurring because households basically spend less and that's occurring because they're paying more for mortgages and paying more for their car loans, they're paying more for debt. So, as rates increase further, you know, the drag on household finances from higher interest rates is going to have an impact on consumption, is going to have an impact on housing, it's going to have an impact on a broad range of things and that's the mechanism through which interest rates generally impact the economy. So, it is going to take a bite out of household budgets. There's no question. I mean, that's why they're doing it. Now, that bite isn't going to be overly dramatic in our mind. I mean, household balance sheets are very strong. The job market is very, very strong. The recovery is very strong, we're just talking about at the margin, you know, slowing things relative to what is pretty darn optimistic base case scenario.

SM: And are there actual positive impacts as well? Are there upsides for consumers or I maybe investors of higher interest rates?

JFP: For sure, right. I mean, if you are holding deposits, if you rely on fixed income investments, generally speaking, higher interest rates are going to benefit you, right, you're going to earn more for those investments. So, there is a bit of an offset. But the principal reason for raising interest rates is slow consumption.

SM: So, the housing market has been on fire and continues to be. We’re heading into a spring season now. Do the higher interest rates and I don't know if a quarter point does it, but does that help to sort of calm the waters a little bit on the housing market front?

JFP: Hopefully it does. But there's some kind of competing dynamics here. The first is this is the first interest rate increase. It is not inconceivable that you have folks kind of rush into the market in the short run to try and beat what are now pretty widely expected further interest rate increases. It's possible in the short run, things get a little bit even harder in the housing market. Then you got to layer in some kind of Ukraine related developments, so set aside the impact on inflation. What's happened as a result of the war is there has been a pretty significant flight to safety. So, you've had global investors pile into the U. S. Dollar and pile into US Treasuries. And as a result of that, you've seen a pretty significant reduction in, say, the yield on five-year government debt in Canada, the US, you know, in the order of 30 40 basis points. So while we're ramping up short term interest rates, interest rates at the longer ends of folks that have, say five year mortgages, the cost of funding those mortgages has been following the last couple—well, last week or so. In the short run, there's a bit of an offset, you know, how that evolves obviously is a function of how the conflict in Ukraine evolves and whether or not there is a greater financial stability and greater financial concern. But for the time being, you're getting this bit of an offset, higher short term interest rates, lower long term interest rates.

SM: You were among those calling on the Bank of Canada to increase rates, even hoping that they would have done it sooner than they have. But now they've done it. I mean, clearly you thought it was the right thing to do. What impact do you think it will have over the coming months?

JFP: Well, if you kind of read through the Bank of Canada’s tea leaves and read their statement, it seems pretty clear that they are much more worried about the inflation outlook than they were in their last statement. So, as a result of that, you know, we are more confident about the rate forecasting area that we have, which is a pretty aggressive series of rate increases over the year. And in particular, we think rates are going to go by 50 basis points in April. So, we're looking at the statement, we're looking at inflation developments, we're looking at the evolution of commodity prices and to us that all suggests still, actually maybe even more so, that the next move will be a 50 basis point move as opposed to 25 basis point move. So an acceleration of the pace of tightening in the short run.

SM: Okay, so last question—by the end of the year, what's the interest rate going to be at?

JFP: So, we think that the Bank of Canada policy rate by the end of the year is 2% after the move this morning it’s currently 0.5%.

SM: Thanks again for coming on. J. F. We always appreciate you taking the time to talk to us.

JFP: You’re very welcome, Steve.

SM: We’ve been talking to Jean-François Perrault, the Chief Economist at Scotiabank.