Was the Bank of Canada’s pre-emptive strike against inflation premature?

Published in the Globe and Mail 

The Bank of Canada raised its policy rate to 2.5 per cent on Wednesday morning.

We understand the thinking. However, given the available data and the current climate of extreme uncertainty, we believe the bank should have held rates steady.

First, let’s look at how Governor Tiff Macklem telegraphed the hike during his Oct. 17 press briefing at the International Monetary Fund meeting in Thailand. Before the briefing , markets had priced in a low probability of a rate increase. Following his remarks, that probability rose to almost 90 per cent ahead of the announcement, according to Bloomberg data.

Markets were reacting to the Mr. Macklem’s more pessimistic inflation outlook. He noted that oil prices had been persistently higher than the bank expected when it published its last forecast in July. Mr. Macklem said, “If oil prices stay around $100, we expect inflation to gradually drift up from where it is today.” He then added, “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?”

The first part of Mr. Macklem’s statement is consistent with the bank’s new projection model, Prima, which breaks down the effects of shocks in a much more granular way than its previous forecasting models. A recent Bank of Canada study uses Prima to contrast the impact on headline inflation of a short, sharp increase in energy prices with that of a more prolonged increase. In the first scenario, headline inflation rises briefly before returning to its pre-shock level, with almost no pass-through to other consumer prices. In the second – a situation it appears we find ourselves in today – inflation stays elevated for much longer as firms anticipate higher costs and pass them on to consumers.

But these projections alone may not justify a rate hike. So, what data might have supported such a move?

We see two key pieces. First, producer prices rose 14.5 per cent in the year to September, while raw material prices increased by a whopping 27 per cent over the same period. These prices often signal future price increases elsewhere in the economy, and the bank highlighted concerns over increased pass-through.

Second, the bank published its survey of consumer expectations on Oct. 19, which showed that, for the first time since the post-pandemic inflation surge, five-year-ahead inflation expectations are almost 4 per cent, nearly the same level as the already elevated one-year-ahead expectations. Given the bank’s delayed response to the last inflation surge, when inflation shot up to levels not seen in decades, getting ahead of any de-anchoring of inflation expectations makes sense.

However, we think there are too many other pieces of data that are suggestive of a hold – at least for now.

Headline inflation remained almost unchanged in September, ticking up slightly, from 3 per cent in August to 3.1 per cent. From a pass-through perspective, core inflation measures remained subdued, moving down slightly between August and September: Consumer Price Index-trim fell from 1.9 per cent to 1.8 per cent, and CPI-median from 2 per cent to 1.9 per cent. These measures are considered good predictors of where inflation may be headed in the short to medium term, so they don’t set off any alarm bells.

The economic outlook also argues for caution. Prospects for fourth-quarter growth have faded, prompting most forecasters to lower their projections. On Oct. 20, the Parliamentary Budget Office published its economic and fiscal outlook, lowering its 2026 growth forecast to 0.9 per cent, down from 1.1 per cent in June. The bank itself estimates that if the new U.S. tariffs remain in place, including those scheduled to take effect on Oct. 30, fourth-quarter growth could be halved to less than 1 per cent. And the labour market statistics are anything but upbeat. More than 40,000 jobs were lost in August and nearly 70,000 in September, many of them were full-time jobs and many in the core 25-54 age group.

Our view of this data is that there remains slack in the economy, which will have the effect of slowing price increases even in the face of increased energy costs. Raising rates risks aggravating this economic slowdown.

With relatively subdued core inflation, economic slack persisting, and the huge clouds of uncertainty concerning the evolution of the Iran war and whether or not we will reach an agreement to end the trade war with the US, we believe the bank should have waited.