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Interest rates have started to flatten, and some have started to moderate slightly in Canada. Is this the peak? Or is this fools good? Is there another wave of inflation and interest rate increases coming?
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Interest Rate Pause
The Bank of Canada has recently communicated a “pause” on its interest rate increases. Whereas the US Federal Reserve has continued increasing interest rates, albeit at a slower pace of 25 bps. Interestingly, the US Federal Reserve made a point of discussing the Bank of Canada’s “pause”, describing it as “risky”, and fairly blatantly indicating that Interest Rates will continue to increase at a moderate pace. In fairness to the Bank of Canada, they started to increase rates earlier, and faster than the US Federal Reserve, so the Bank of Canada’s “pause”, may only be allowing the US Federal Reserve to catch-up to its posture.
But why would a “pause” be risky? Well inflation is still running at 6.30%, down from a high of 8.10% and the Bank of Canada’s Policy Interest Rate is at 4.50%. We have previously written that historically inflation has not peaked until the Policy Rate is above the rate of inflation here, perhaps by as much as 1.00%. The Bank of Canada’s target inflation rate is 1 to 3%. A “pause” is essentially betting that the inflation rate will continue to decrease, by at least 3.30%, without increasing Interest Rates any further.
The Market took the Bank of Canada’s “pause” to mean that Interest Rates have peaked, and will not go any higher. However, since then, there has been some shockingly good data on jobs, that implies inflation may rear its head again. So why is this “risky”?
Wave of Inflation and Interest Rates
When economists talk about inflation, they speak of waves of inflation, and that is a really good analogy. We will extend this analogy further – lets envision inflation as the ocean, with both an overall tides and individual waves (Side note – only the ocean has perceptible tides, not lakes). The tide represents the overall direction of inflation, either the tide is coming in (inflation is going up), or the tide is going out (inflation is going down). Looking at each individual wave, doesn’t necessarily give you an indication on whether the tide is coming in or going out. The Interest Rate Market in Canada has essentially bet that the tide is going out based on the one wave that just shore… lets hope they have a swimsuit on, because it might get wet.
First, the economy is defying many recent norms. We haven’t seen this level of inflation in several decades, the labor markets continues to be historically tight, we are emerging from a multi-year pandemic, global tensions continue to rise, supply chains are stretched and the reasons go on and on. But lets get back to the ocean analogy, and waves of inflation.
Inflation comes in waves, because it doesn’t happen to everything, everywhere, all at once (Another side note, that looks like an interesting movie albeit a bit odd). Inflation works its way through the economy in waves, and inflation in one part of the economy causes inflation in other parts of the economy, in a sort of spiral. Supplier’s costs go up, suppliers increase prices, consumer pay more, consumers demand more from their employers, supplier’s costs go up, suppliers increase prices and on and on.
Conclusion: Link between Inflation and Interest Rates
And lets remember that really the only way to fight inflation, at least within the mandate of Central Banks, is by raising interest rates. Lets also remember that the Bank of Canada cannot really go in an opposite direction than the US Federal Reserve – we will talk about that in another article as to why.
So, if you want to bet that interest rates have peaked, make sure you have your swimsuit on, as there may be another wave of inflation, and corresponding interest rate increases coming.