The Bank of Canada held its key interest rate at 2.25 per cent on Wednesday amid domestic economic slack and wider disruptions due to the ongoing war in the Middle East.
This decision comes as the central bank steps back to evaluate how the global energy shock will affect the domestic economy and those of Canada’s major trading partners.
Given the weak employment data announced on March 13—84,000 jobs lost in February and a 6.7 per cent unemployment rate—the Bank of Canada will likely turn its attention to identifying when and if demand destruction in Canada’s economy could start due to rising energy prices, fuel surcharges and other price increases linked to the war.
We expect that the Bank of Canada will look through rising oil prices and wait to see how long the conflict plays out, the scope of the damage to energy production infrastructure in the region, the evolution of inflation expectations and if volatile energy prices bleed into core inflation.
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Bank of Canada governor Tiff Macklem sought to downplay any economic boost from the war. He was careful to note that while a sustained increase in oil prices will increase income from energy exports, higher gasoline prices will squeeze Canadian consumers.
So, the central bank is treading carefully around the effects of the war on the domestic economy. The size of the U.S. economy is such that it going to absorb the bulk of the oil shock; prices would need to move well above $125 US per barrel to create a set of conditions where demand destruction south of the border sets in that reduces demand for Canadian exports to the U.S.
Looking ahead
The key for future policy decisions from the Bank of Canada is going to be the duration of the war. A shorter conflict and a move back down in oil prices over the coming months would likely cause a return to the dovish status quo previously articulated by the Bank of Canada.
A longer war that results in much higher oil prices—where topline inflation bleeds into the core—could create conditions where the central bank may have to consider hiking rates.
These conditions represent a true nightmare for central bankers; should demand destruction start, the Bank of Canada will have to contend with whether to cut rates to support the domestic economy as inflation rises due to external events.
Tension between a weak labour market and rising inflation can create conditions in which the Bank of Canada would need to focus on price stability, which is a pre-condition of maximum sustainable employment.
This would result in a toleration of higher unemployment to push inflation back to target—which no one in Ottawa or the rest of Canada would welcome.
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