Bank of Canada expected to raise benchmark rate for first time in three years as oil shock persists

The Bank of Canada is widely expected to raise its benchmark interest rate for the first time in three years on Wednesday in a bid to prevent high oil prices from becoming a broader and more entrenched inflation problem.

However, there is an unusual amount of uncertainty surrounding the decision, with hawkish messaging from the central bank appearing at odds with recent data showing inflation remains relatively well contained.

The bank’s governing council has kept the policy rate steady at 2.25 per cent since last October, with one eye on the economic damage caused by the trade war with the United States and the other on the global energy shock tied to the war in the Middle East.

As oil prices have once again rocketed higher in recent months, Governor Tiff Macklem has increasingly emphasized the upside inflation risk – to the point where financial markets now expect the bank to deliver its first rate hike since the end of the postpandemic tightening cycle in the summer of 2023.

A rate hike, if it happens, will land at a delicate moment for the Canadian economy. The housing market is in a deep slump, unemployment is still elevated and the U.S. has threatened additional tariffs on the Canadian auto sector in the coming months.

“A rate hike might be a fine decision if things go well in future trade talks and energy prices stay high,” said Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce. “But it could prove to be a policy mistake if the trends go in the other direction for both oil prices and trade policy.”

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Bay Street has long expected the central bank’s next move would be a hike, and traders and analysts have been anticipating several rate increases over the next 12 months. Over the past week, however, there has been a rapid reassessment of when this tightening cycle will start.

In a matter of days, financial markets went from pricing in a roughly 35-per-cent chance of a quarter-point hike on Oct. 28 to putting the odds at nearly 90 per cent, according to Bloomberg data. A number of prominent Bay Street forecasters flipped their calls last week from hold to hike.

The stampede followed hawkish remarks Mr. Macklem made on Oct. 17 at the annual International Monetary Fund meeting in Bangkok.

“If oil prices stay around US$100, we expect inflation to gradually drift up from where it is today: 3 per cent,” the Governor said on a call with reporters, noting that there are few signs the war between the United States and Iran, which has closed the Strait of Hormuz to most oil tanker traffic, will end any time soon.

He said the bank will likely raise its inflation forecast when it publishes its quarterly Monetary Policy Report alongside the rate decision.

“The question we’re going to be asking ourselves is: Is inflation likely to come back down toward our [2-per-cent] target on its own, or are we going to have to raise interest rates to influence the path, nudge the path for inflation back toward the target?” he said.

Since his comments, oil prices have continued to rise, with the price of a barrel of Brent Crude hitting a six-month high of US$116 on Friday and West Texas Intermediate trading at US$103.

Several other central banks, including the U.S. Federal Reserve, raised interest rates last month partly in response to high energy prices. The Fed’s next rate decision is also on Wednesday. It’s widely expected to hold its policy rate steady in the lead-up to the Nov. 3 U.S. midterm elections, before resuming rate hikes later in the year.

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Despite Mr. Macklem’s focus on oil prices, there is little evidence the energy shock is pushing up other consumer prices across the Canadian economy – at least so far.

Annual consumer price index inflation hit 3.1 per cent in September, up from 3 per cent the month before. But the increase was largely driven by a 6.1-per-cent monthly jump in gasoline prices.

Excluding energy, the rate of inflation eased to 2.2 per cent from 2.4 per cent the month before, while the Bank of Canada’s two preferred measures of underlying inflation each fell by a notch to 1.9 per cent and 1.8 per cent.

“In my view, the data on aggregate is not convincing to hike,” said Jeremy Kronick, chief executive officer of the C.D. Howe Institute and head of its monetary policy council. “So to me, the market is reacting almost entirely to Governor Macklem’s comments in Bangkok.”

That creates the possibility that bond traders have misinterpreted the Governor’s remarks, and could be in for a surprise on Wednesday. The bank has surprised the market on a number of occasions over the past decade, cutting, holding or raising interest rates when traders were betting on something else.

However, there is at least one other argument for a hike this week, Mr. Kronick said. The bank’s latest quarterly consumer survey, published last week, showed a sharp jump in longer-term inflation expectations, while its quarterly business survey showed companies increasingly plan to pass rising costs along to customers. Central bankers pay close attention to where individuals and businesses think inflation is heading, because expectations of rising prices can become a self-fulfilling prophecy.

You can look through supply-side price shocks “up to the point where expectations start to become de-anchored,” Mr. Kronick said. “But once you get into that situation, especially with longer-term inflation expectations, then you have to move.”

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Looking further out, markets expect the bank to deliver four quarter-point rate hikes by the end of 2027 – including one this week – which would take the policy rate to 3.25 per cent.

Nathan Janzen, assistant chief economist at Royal Bank of Canada, said bond traders are pricing in these rate hikes because they expect the Canadian economy to improve in the coming quarters. “If the economy is normalizing, then there’s room for interest rates to normalize,” he said.

For most Canadian borrowers, it’s this direction of travel that matters more than whether the central bank raises rates this week or holds off until later this year or early next year, he added.

Longer-term Canadian bond yields, which underpin mortgages, have already climbed in recent months, partly based on rising interest rates in the United States and partly based on expectations of future Bank of Canada rate hikes.

“Shifting the timing by three months doesn’t make that big of a difference for a five-year or 10-year [bond],” Mr. Janzen said. “As long as they’re going to hike sometime within the next few months, then for a lot of households and businesses that are borrowing at fixed rates, it doesn’t make that big of a difference when that initial interest rate hike comes.”