Speculation is growing that the central bank could move rates higher if oil prices continue to surge
The Bank of Canada’s decision to hold interest rates steady again on Wednesday came as no surprise, but a fresh upsurge in oil prices and a new escalation in the US-Iran war are raising questions about whether hikes could be ahead before the end of the year.
The central bank said in its latest statement that long-term inflation expectations “remain well anchored” despite the conflict’s latest flareup, although it highlighted that the global inflation outlook remains highly dependent on how long that war drags on.
Bank of Montreal (BMO) chief economist Doug Porter (pictured top) told Canadian Mortgage Professional the Bank’s language suggested it didn’t see signs of higher oil prices feeding into inflation more broadly yet, but that it was attuned to the risk.
All bets could be off if the Iran conflict rumbles on with no sign of a resolution. “I’ve been very much of the view that the Bank’s not going to raise rates, that they’re going to decide they don’t have to,” Porter said.
“The longer these oil prices stay at these levels, the less confident I am in that call. It does increase the risk that the Bank at one point might feel that they have to raise interest rates.”
Financial markets have already begun to price in the possibility of rate increases by the central bank, with better-than-even odds of a hike before the end of the year.
As expected, BoC governor Tiff Macklem gave little away about the Bank’s path ahead in his Wednesday press conference but left the door open for rate hikes if the inflation outlook deteriorates.
“Clearly, if oil prices go higher, they stay higher,” he said. “The likelihood that that gets passed on, broadens risks. There’s a progression from broadening to persistence.
“And yes, if that happens, we may well need to raise interest rates. That’s not our base case, but it is a serious risk.”
Scars of 2022 remain fresh for BoC decisionmakers
Some of the Bank’s concern on the inflation outlook may stem from its experience in 2022, when the consumer price index (CPI) soared to a multi-decade high of 8.1% in the middle of the year.
That followed a prolonged spell with the Bank’s policy rate at a rock-bottom 0.25% and led to a series of aggressive hikes by the central bank as it attempted to bring inflation under control.
The current inflation rate is well below that level, clocking in at 3.2% in May. But Porter said that rapid 2022 inflation runup is potentially looming large in Bank decisionmakers’ minds as they contemplate the possible impact of rising oil prices.
“I think given the episode we went through four years ago, they’re just incredibly concerned about the possibility of inflation lingering, even if initially it’s driven by oil prices,” he said.
“I think in general they believe that people are more sensitive to inflation now than they would have been, say, five or six years ago, and they feel they might have to react.”
Reasons for optimism from central bank’s latest announcement
For now, the Bank is keeping its powder dry as it waits to see how long the Iran war continues and whether US and Iranian negotiators can strike a ceasefire deal.
There remained no hint of progress midweek, with the US launching new strikes on Iran as President Trump warned that power plants and bridges could be targeted if an agreement wasn’t reached.
One detail from Wednesday’s announcement is reassuring for the medium-term outlook, Porter said: even with months of volatility in oil prices, the Bank has not made any significant change to its inflation forecasts for next year or the year after, signalling that policymakers still see the current pressure as transitory rather than a lasting shift.
That means while rate hikes might be needed if oil prices continue to tick higher in the months ahead, the central bank doesn’t currently see that as the most likely outcome.
“They still, at their heart, believe that inflation is going to come back down to 2% in the medium term,” Porter said. “And they very much view this as a temporary runup in inflation, what we’re dealing with now.”
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