Bank of Canada’s major interest rate hike is a signal the economy is in really big trouble

The Bank of Canada has pulled a new anti-inflation tool out of its pocket: a poker face.

Until Wednesday morning, the market chatter and the reading of the tea leaves was all about whether the central bank would raise its key rate by half a percentage point or dare to follow the U.S. Federal Reserve and go up three-quarters.

Surprise!

By taking pretty much everyone by storm and raising its key interest rates by a full percentage point, the central bank is leaving nothing to chance. They are pounding us with their message, loud and clear: they will not stop raising rates, dramatically, until inflation is conquered.

They call it “front-end loading” so they don’t have to pound us with even more later on.

“The Bank is guarding against the risk that high inflation becomes entrenched because if it does, restoring price stability will require even higher interest rates, leading to a weaker economy,” the bank’s quarterly report states.

For now, they’re essentially popping what remains of any Canadian housing bubble, hampering consumers’ ability to spend, betting on energy prices declining and assuming the global economy is grinding to a near-halt.

All of those factors will lead, eventually, to inflation coming back down to earth. Not right away, though. It probably won’t even peak until later this year — much later than what the bank used to think, even just three months ago.

So they’re also using their poker face to shock us out of our unhinged expectations for inflation. Normally, central bankers would at least give a hint they are about to make a giant, historic move. This time, we knew they would make a major hike, but not quite this big.

Point taken.

And for sure, the move is historic, not just for its surprise. It’s the first time for a 100 basis-point increase since 1998, when the Canadian dollar was sinking in the throes of the Asian financial crisis.

But big moves in the bank’s key instrument in controlling inflation are not unusual at crisis points. They cut 100 basis points in October 2001 in the wake of the 9/11 attacks on the World Trade towers. They coordinated a large cut with other countries in October 2008 as big financial institutions failed and global trade collapsed in the outset of the Great Financial Crisis. They cut 75 points at the beginning of the pandemic, in tandem with big spending from the federal government.

Large, wake-up slaps in the face from the central bank signal the economy is in really big trouble. But this time, some of that trouble comes from missteps by the world’s central banks themselves.

Indeed, the bank’s report has a whole appendix on what they got wrong, which is refreshing. For more than a year, they and other central banks have been underestimating inflation because they didn’t foresee the surge in commodity prices, nor did they anticipate supply shortages or higher shipping costs. In the Canadian economy, they didn’t expect us to bounce back from the pandemic recession so fast, and they certainly didn’t see the big pandemic increase in house prices in the works.

Now, our collective obsession with housing the force that picked us up out of recession — is the thing that will drag us back down to the doldrums, with a push from the central bank.

“Households seeking to renew or take on a new mortgage now face five-year fixed mortgage rates at their highest level since 2010,” the bank’s report warns.

In part, it’s the price Canadians are paying for the Bank of Canada focusing last year on allowing the labour market to grow as much as it possibly could, promising Canadians rates would stay low for a very long time, and taking too much time to rein in their accommodations for the pandemic.

To be clear, the central bank doesn’t see a recession in our future. Their forecast is for the proverbial soft landing, with economic growth slowing down to 1.8 per cent next year before revving back up a bit to 2.4 per cent in 2024. In the long run, housing will eventually come back because immigration continues unabated and we don’t have enough homes for everyone.

For now, though, the bank’s fear is that inflation expectations remain unhinged, we get sucked into a wage-price spiral where workers demand better pay to cover higher costs, prompting businesses to raise their prices to deal with higher wages.

It’s the only factor in the bank’s quarterly report that warrants an explicit mention of recession. And it’s what could push the bank to use its interest rate to hammer with even more force, driving us into a contraction.

So the poker face could well come in handy again if we don’t all take a deep breath and trust that inflation will fade away. Let’s hope they don’t get it wrong this time.

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