The Bank of Canada surprised markets with a larger than expected full point increase in its overnight rate, bringing its key policy rate to 2.5 per cent. In the statement accompanying the decision, the Bank noted that inflation is higher and more persistent than the Bank expected and will likely trend near 8 per cent through the summer before easing to 3 per cent by the end of 2023. Core inflation, which removes the more volatile components of the CPI, is rising at between 4 and 5 per cent, indicating broad price pressures throughout the economy. While the economy is experience strong growth this year, the impact of Bank of Canada rate tightening is likely to slow the economic growth from 3.5 per cent this year to just 1.75 per cent in 2023.
The overnight rate is now within the Bank's estimate of "neutral", or the level of its policy rate at which inflation should run at 2 per cent and the economy is operating at full-capacity. However, it is clear from the Bank's statement that it expects it will have to tighten rates above neutral to bring inflation, and expectations of inflation, back to its 2 per cent target level. As of this morning, financial markets expect that the Bank of Canada will raise its overnight rate to above 3 per cent, and those expectations are currently embedded in 5-year fixed mortgage rates which have exceeded 5 per cent for the first time in over a decade. While there are encouraging, early signs that inflation is peaking, we will need to see a sustained decline in the rate of inflation over the next several months to see any relief on mortgage rates.
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