Bank of Canada could face a painful decision if 'shock therapy' fails to snuff out inflation, says advisor
The Bank of Canada surprised no one when it followed through on earlier promises to act aggressively if needed against inflation.
Canada’s central bank announced a half-percentage point rate hike on Wednesday – its second after the one in April – bringing its policy rate to 1.50%. Its decision comes two weeks after Statistics Canada revealed that annual inflation came in at a fresh three-decade high of 6.8% in April. The BoC also warned that it may announce more supersized hikes in its next meetings.
For Markus Muhs, a financial advisor and portfolio manager in Edmonton, it’s a case of central bank policy playing catch-up with reality.
“Certainly, this rate hike and probably a few more are needed, but it’s frustrating that they waited this long and are forced to now hike so quickly,” says the Senior Portfolio Manager at Muhs Wealth Partners, Canaccord Genuity Wealth Management.
Like many other observers, Muhs argues that both the BoC were slow to act on inflation coming out of COVID. In the case of Canada, he says the first inklings of inflation were already present in elevated monthly CPI prints reported in the fall of 2020.
“If you took the inflation numbers from Q4 2020 and multiplied by 4, you were already over 3%, and isn’t it the BoC’s mandate to act when inflation breaches 3%?” Muhs says. “We could have done just a quarter point then, bringing us up from historic lows, then maybe slowly hiked a quarter point at a time through 2021.”
Canada’s central bank might deserve some consideration for not acting then; Tiff Macklem had only been appointed BoC Governor a few months prior, and policymakers were still navigating through the global pandemic crisis and its economic fallout. But Muhs maintains that it should have taken action immediately after April 2021, when monthly inflation came in at an overheated 0.57%.
“By waiting, the BoC and the Fed have both been forced to use shock therapy, with these 50bp hikes that collectively impacted the consumer, stock, and bond investors,” he says.
Muhs also has concerns about how much the Canadian economy has come to rely on real estate development, reselling, and financing and “what might happen when the punch bowl gets taken away.” While the Alberta economy is not as vulnerable as it is far less inflated, recent figures from the Canadian Real Estate Association suggest interest rate increases are already starting to weigh on housing markets, which could be a sign of worse things to come.
“I think the BoC knows this, and it limits the terminal rate they can go to in their rate hiking cycle,” Muhs says. “That might mean having to choose between letting inflation burn, or sacrificing the real estate market. If necessary, they’ll choose the former, and higher inflation could lead to negative real GDP growth and thus a technical recession.”
Of course, that reckoning might not come at all. Assuming the central bank succeeds with its supersized rate hikes, it may be able to tamp down inflation before interest rates put Canadian homeowners and mortgage holders in any jeopardy. And while the U.S. housing debt situation may not be as dire, the Fed is under similar pressure to get prices under control as quickly as possible.
“Both in the U.S. and Canada, the May inflation print will be of massive importance,” Muhs says. “Will we see a decline, maybe giving central banks the leeway to ease off on the accelerator, for bond yields to come down a bit, and for stocks to take a breather? Or do we see it move up, and do we start worrying about the central banks ‘doing more damage’?”
