Getting inflation back to target

Governor Tiff Macklem talks about the Bank of Canada’s decision yesterday to raise its policy interest rate. He explains that after two years of extraordinary stimulus, we are now on a path of rising interest rates.

Policy rate

We decided yesterday to raise the policy interest rate by 25 basis points to half of 1%. The Bank will also be considering when to allow its holdings of Government of Canada bonds to begin to decline —a process known as quantitative tightening (QT). The timing and pace of further increases in the policy rate, and the start of QT, will be guided by the Bank’s ongoing assessment of the economy and its commitment to achieving the 2% inflation target.

Our strong recovery continues

In January’s Monetary Policy Report, we told Canadians that the emergency monetary policy put in place to support the economy through the pandemic was no longer needed. We ended our exceptional forward guidance and signalled that a rising path for interest rates was on the horizon.

Since then, economic conditions have unfolded largely as we expected. GDP growth in the fourth quarter of 2021 was strong at 6.7%, reinforcing our view that the economy is once again producing at its full capacity. Inflation remains too high at around 5%. The invasion of Ukraine is pushing up prices for both energy and food-related commodities. This is a major new source of uncertainty.

Understanding the unusual rise in inflation

While we expect inflation to come down in the second half of this year as the pandemic eases, it is currently well above our target. This is because of three main factors.

• Stuck at home during the pandemic, Canadians spent less on services and more on goods. This shift in demand away from services, combined with global supply disruptions, has put upward pressure on the price of goods.
• Prices have increased for items beyond those directly affected by supply chain disruptions. For example:
• Higher oil prices have contributed to increased transportation costs, which, in turn, makes all goods more expensive.
• Food prices are being affected by extreme weather that has damaged crops across many regions.
• Strong demand for single-family homes in Canada is pushing up housing prices.
• In addition to these issues of supply and demand, the overall strength of the Canadian recovery is also driving inflation. While higher interest rates can’t resolve supply chain disruptions or lower the cost of oil, they do make borrowing more expensive, which slows demand and dampens the pace of inflation.

Quantitative tightening

To support the economy during the pandemic, we undertook a program called quantitative easing— which helped lower borrowing costs for households, businesses and governments.

With the decision yesterday to raise the policy rate, a natural next step would be quantitative tightening. Instead of buying bonds to lower the costs of borrowing, this means letting our balance sheet shrink by allowing government bonds to mature.

QT would complement increases in the policy rate, putting upward pressure on longer-term interest rates. But it is important to underline that the Bank’s policy interest rate remains the most important monetary policy tool at our disposal to return inflation to the 2% target.