Is the Bank of Canada Lagging?

🚨Slashing Interest Rates🚨 

As of the August 2024 report, Canada’s inflation rate has finally hit the Bank of Canada’s (BoC) target of 2%. This milestone marks a significant achievement after a prolonged period of high inflation. However, despite this progress, the BoC has been slow to adjust its interest rates to a more neutral level, leaving it in the restrictive zone for the current economic climate. 

📉 The Current Economic Landscape 

The BoC’s primary tool for controlling inflation is the policy interest rate. Over the past few years, the BoC aggressively raised interest rates to combat soaring inflation, which peaked at 8.1% in the summer of 2022. These rate hikes were necessary to cool down the overheated economy, but now that inflation has returned to the 2% target, the question arises: why haven’t interest rates been lowered to a more neutral rate to correspond with the inflation target? 

📉 Understanding the Neutral Rate 

The neutral interest rate is the rate at which monetary policy neither stimulates nor restricts economic growth. For Canada, this rate is estimated to be between 2.25% and 3.25% but could be also lower as the economy has been sputtering and stalling out. Currently, the BoC’s policy rate stands at 4.25%, which is above the neutral range and is still considered overly restrictive. This means that the current interest rates are still putting the brakes on economic activity, which hinders growth and could prolong Canadians’ recovery for an extended number of years. 

📉 3 Reasons for Lowering Interest Rates at a Higher Pace 

As high inflation has been beaten down, maintaining high interest rates above the neutral rate could have several negative consequences if kept restrictive for too long: 

1. Economic Growth: High interest rates can stifle economic growth by making borrowing more expensive for businesses and consumers. This can lead to reduced investment and spending, slowing down the economy even further and delaying the explanation period for several years. 
2. Employment: Restrictive monetary policy can also impact employment. Higher borrowing costs can lead to lower business expansion and hiring, potentially increasing unemployment rates even further.
3. Consumer Spending: Consumers are less likely to take out loans for big-ticket items like homes and cars when high interest rates have impacted their debt levels, creating an exhausted consumer and stalling economic recovery.

📉 The BoC’s Cautious Approach 

The BoC has been cautious in its approach to cutting interest rates, likely due to uncertainties in the global economic environment and potential risks of inflation rebounding. However, with inflation at the target rate of 2%, there is a growing argument for the BoC to act more decisively in lowering rates to the neutral level to see if the economy can support itself without needing stimulus to prop it up. 

While the BoC’s cautious stance is understandable for beginning the rate cut cycle, the current economic indicators suggest that it may be time the BoC to worry less about inflation taking an up-turn and adjust interest rates to a neutral level at a much quicker pace. Doing so can help reignite productivity and economic activity, leading to a rise in employment, and business endeavors. By changing to a proactive stance, the BoC can ensure a more robust and sustained recovery as consumers dig themselves out of debt levels not seen since the early 1990s, before peaking to around an 83.6% debt-to-GDP ratio in 1996.