On Wednesday, the Bank of Canada made the decision to keep its key interest rate steady at five percent, a move that reflects the delicate balancing act it faces amid signs of a faltering economy and persistent inflation. This decision comes as a response to recent evidence suggesting that excess demand in the economy is easing, while also acknowledging the lagging effects of monetary policy. In this article, we will explore the factors behind the Bank of Canada’s decision, its concerns about inflationary pressures, and the challenges it faces in navigating the economic landscape.

Inflation Remains a Concern

Canada’s inflation rate stood at 3.3 percent in July, a noticeable increase from the previous month’s 2.8 percent. While inflation has slowed since the previous summer, it is expected to hover around three percent for the foreseeable future. The central bank recognizes that inflation could spike further due to higher gasoline prices before gradually subsiding. This persistent inflationary pressure is a key factor influencing the Bank of Canada’s decisions regarding interest rates.

Hawkish Tone and the Door to Rate Hikes

Despite maintaining the current interest rate, the Bank of Canada is keeping the door open to the possibility of future rate hikes. It maintains a hawkish tone, indicating that its governing council is ready to raise interest rates further if necessary. This stance reflects the central bank’s commitment to curbing inflation and ensuring economic stability.

Economic Challenges Ahead

Recent economic data, including a contraction in real GDP during the second quarter, has contributed to the Bank of Canada’s decision to hold the key interest rate steady. Canada’s labor market has also shown signs of weakening, with the unemployment rate rising for three consecutive months. This combination of slowing economic growth and stubborn inflation poses a significant challenge.

BMO chief economist Douglas Porter suggests that while the central bank has left the door open for future rate hikes, the likelihood of further increases may be limited if economic growth remains subdued and core inflation continues to gradually decrease. He also notes that a recession is a possibility if economic growth stalls over the next few quarters.

Navigating the Rate Hike Path

The Bank of Canada faces a delicate balancing act. It must avoid excessive rate hikes that could stifle economic growth and lead to a recession while also preventing speculation about rate cuts that could trigger a demand frenzy. Earlier in the year, the central bank had announced a pause on rate hikes, only to reverse course in June due to stronger-than-expected economic performance and a rebounding housing market.

Porter suggests that the Bank of Canada’s messaging regarding the pause earlier in the year was somewhat “unfortunate” as it raised expectations that rate hikes were concluded. Nevertheless, the central bank has already raised its key interest rate ten times since March 2022, marking the highest level since 2001. These rate hikes are expected to continue impacting the economy, slowing consumer demand, and dampening business investment. Economists estimate that it takes one to two years for a rate hike to fully affect demand and business activity.

Rate Forecast

The Bank of Canada’s decision to hold its key interest rate steady reflects the complex economic landscape it currently faces. With inflation remaining a concern and economic growth showing signs of weakness, the central bank must carefully navigate the path forward. While it leaves the door open to future rate hikes, it will likely proceed cautiously to strike the right balance between controlling inflation and supporting economic growth. Bank of Canada governor Tiff Macklem’s upcoming news conference will shed further light on the central bank’s outlook and strategy in these uncertain times.