Peak Rates in Sight But Don’t Expect Cuts Soon

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Benjamin Tal

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Benjamin Tal, deputy chief economist, CIBC.

If you look at the overall situation, it’s possible that we are already in a technical recession. And if not, it’s coming.

So, our call is that it’s going to be a mild recession at this point. The reason is that the impact is going to be mostly on GDP. You will see negative GDP growth maybe, but not a significant impact on the labour market. It’s all a function of how high interest rates will be rising. Clearly, the Bank of Canada is fighting inflation that we haven’t seen in many, many years, and they mean business. They are very aggressive when it comes to the language and action regarding fighting inflation because you give the Bank of Canada two options: one is a recession, the other is inflation. They will take a recession any day. They will make sure that we know that they mean business when it comes to fighting inflation.

So at the end of the day, when we talk to clients about the situation, it’s really not about inflation. It’s about the cost of bringing inflation down to 2%. It seems that the Bank of Canada is starting to slow down, the market gave the Bank of Canada a green light to go 75 basis points in the last move. They chose to go 50. The reason is overshooting. Every economic recession over the past 20, 30 years was helped if not caused by monetary policy error in which central banks raise interest rates way too quickly. And that’s something that the Bank of Canada is trying to avoid. At the same time, remember, they have to make sure that inflation expectations are not rising dramatically, and that’s more or less where we are. So the last move was 50 basis points, but they’re not done. Our call is that the Bank of Canada will raise interest rates from the current 3.75% to about 4.25, maybe four and a half by the end of the year. So another 50 to 75 basis points before they call it a day. That’s something that is extremely important to understand.

Now, much more important is how long they will keep interest rates at that level. In my opinion, they will keep it at least for a year, until 2024. Why? Because you want to make sure that inflation is dead. You want to make sure that you don’t repeat the past mistakes of the 1980s when monetary policy was eased prematurely and we had a double-dip recession. So they will take their time before they cut interest rates and they are very clear about it.

When they cut interest rates, the question is by how much? We have to realize that we are facing three major inflationary forces. We have deglobalization, we have just-in-case inventories, and we have a situation in which the labour market is relatively tight and wages are rising. This might mean that the inflationary forces beneath are relatively strong. At the same time, the inflation target is the same, 2%. It’s not going to change. And in the foreseeable future, the Bank of Canada will not change that target. So you have a target that is the same. The forces beneath are stronger, by definition, interest rates have to be higher than they were before in order to keep that target at 2%. So if before the Bank of Canada rates was 1.75 before we started this madness, and now it’s going to 4.25, four and a half, staying there for a year. It’s not going down in 2024. By how much? I say by 1%, 1.25 going to 2.75, which is a full percent higher than the rate before reflecting those inflationary forces.

So that’s more or less where we are. That’s consistent with the mild recession, with no major issues in the labour market. With the labour market basically bleeding vacancies as opposed to jobs.

However, the other scenario, which is the overshooting scenario in which inflation will be more sticky than expected and the Bank of Canada will have to go higher. Higher means five, five and half percent. That will be pure overshooting. That will take the economy into a real recession with the labour market struggling, the unemployment rate rising and interest rates actually going down in 2023 because of that overshooting.

That overshooting scenario, the risky scenario at this point is about 20-30% probability. The most likely scenario is the mild recession with interest rates rising to 4.25, four and a half. The Bank of Canada is trying not to overshoot and everything depends on where inflation will be. And we are seeing some good news. Inflation is slowing down and the most important story is that the external shock to inflation, namely supply chain, is starting to diminish. And that’s extremely important because the more you see supply chain diminishing, the more power the Bank of Canada has over inflation.

So overall, we are maybe entering a recession, but it’s a technical recession and the Bank of Canada will try not to overshoot. Overshooting will lead to a more significant recession.