Where will interest rates go if inflation stays high in 2023?

The possibility of stubbornly high inflation is the "key risk" facing the Bank, says CEO

Where will interest rates go if inflation stays high in 2023?

While the Bank of Canada appears to be nearing an end on its interest rate-hiking cycle for now, one factor could potentially torpedo those plans: the possibility that inflation remains stubbornly high or gets worse.

Consumer price index (CPI) inflation has crept downwards for three consecutive months after hitting a 39-year high in the middle of the summer, although at 6.9% it remains significantly higher than the central bank’s 2% target.

Runaway price growth has been the Bank’s main reason for aggressive action on its benchmark rate this year, and while inflation fell again in September, it came in marginally higher than most observers had expected.

The prospect of inflation continuing to fall at a slower rate than the Bank of Canada hopes is the “key risk” facing the institution at present, according to Ratehub.ca co-CEO and president of the CanWise mortgage lender James Laird (pictured top).

He told Canadian Mortgage Professional that the possibility of more persistent inflation than currently expected could convince the Bank that its trendsetting rate needs to rise even further than the 4.25% many economists believe will be its terminal level for now.

Given the economic uncertainty that would likely increase as a result, it’s a possibility that could have a noteworthy impact on the country’s housing market, he added.

Read more: Bank of Canada makes another big rate hike

“They’re saying [their] target [is] 3% inflation towards the end of 2023. If they’re not seeing that trend down towards 3% in a year or so, they’re going to have to raise rates further,” he said. “And then we’ll be back to where we were last month where the market will be kind of up in the air and a lot of people will be sitting on the sidelines and things like that.

“So I think that’s the key thing to watch over the next 12 months: is this truly the peak and now we’re going to have a nice steady decline in inflation – allowing the central bank to leave rates where they are and then possibly drop them in 12 to 18 months? Or is inflation going to be more stubborn than they are hoping or thinking, which will require more sizeable rate hikes to get it going in the direction they want it to?”

If inflation continues to march steadily downwards towards 3%, that means rates are likely to remain at or around their current level – or even tick lower well into 2023 depending on how the economy is performing. In that eventuality, choosing a variable rate remains the right strategy, Laird said.

On the other hand, if the Bank deems that inflation is too sticky to justify not raising rates further, a fixed option could offer greater peace of mind to customers whose budgets would be overly stretched on a variable, he added.

Read more: How many more rate hikes will the Bank of Canada make?

CIBC’s deputy chief economist Benjamin Tal indicated to CMP last week that having to raise rates higher than originally planned would be the central bank’s “nightmare scenario,” one that would risk overshooting and plunging Canada into a potentially deep recession.

BMO chief economist Doug Porter, meanwhile, said his bank had remained consistent in its concern in recent years that inflation would be more difficult to remove from the economy, “now that it’s become somewhat entrenched.”

Still, he said the fact that the Bank of Canada had decided to hike its policy rate by 0.5%, rather than the three-quarter-point jump anticipated by markets, showed that it was marching to its own drumbeat and wouldn’t be overtly influenced by what analysts expected.

“It’s now quite obvious that the Bank of Canada is not going to be beholden to what the market expects. That’s actually the third time this year that the Bank of Canada’s done something a little bit different than what the market expected,” he said. “Clearly, the Bank is not afraid to just surprise the markets.”

The fact that the Canadian dollar strengthened after the meeting despite the move not being expected by markets is a positive sign from the Bank’s perspective, he added.

“To me, that really does show that the Bank has a lot of options at its disposal here – that the Canadian dollar is not going to suffer just because they decide to go a little bit less than what the market anticipates.”