TL;DR

Based on the Bank of Canada’s summary of deliberations released July 26, it's evident that the decision to raise the key overnight interest rate to five per cent on July 12 was driven by concerns about high inflation expectations and the persistence of excess demand and strong consumer spending. Persistent core inflation above target raised concerns about unanchored inflation expectations.

Canadian economy started the year strong but slowed down in Q2, with GDP contracting by 0.2% in June. Annualized growth rate for Q2 was 1%, lower than the Bank of Canada's projection of 1.5%.Factors include higher interest rates, sluggish foreign demand, and cautious household spending.

Bank of Canada Considered Pausing Rate Increases but Feared Fuelling Inflation

Based on the Bank of Canada’s summary of deliberations released July 26, it's evident that the decision to raise the key overnight interest rate to five per cent on July 12 was driven by concerns about high inflation expectations and the persistence of excess demand and strong consumer spending. The central bankers considered two possible scenarios before making their decision:

1. Lagged Impact of Previous Rate Hikes: The council discussed the possibility that the impact of previous rate hikes was experiencing a delay due to atypical circumstances and the economic effects of the COVID-19 pandemic. Factors such as a buildup of savings for some Canadians and pent-up demand for goods and services were considered. They also looked into supply chain improvements and immigration policy but concluded that the impact of newcomers on consumption was likely neutral.

2. More Restrictive Monetary Policy Needed: The second scenario involved the consideration that a more restrictive monetary policy might be necessary to reduce excess demand and bring inflation back to the two per cent target. Factors such as tight labor markets and household savings still being well above pre-pandemic levels suggested that demand could continue to be stronger than previously forecast.

The central bankers were concerned about core inflation remaining at a range of 3.5 per cent to four per cent for eight months, and the possibility that inflation expectations could remain high, potentially settling above what would be consistent with achieving price stability. This raised the risk of inflation expectations becoming unanchored, making it more difficult to bring inflation back to the target.

The deliberations also included a discussion on balancing the risks of under and over-tightening monetary policy. They noted that these conditions would impact corporate pricing behavior and wage setting, making it more challenging to bring inflation back to the target.

The summary of deliberations also mentioned the risk of over-tightening monetary policy, which could result in economic conditions becoming more painful than necessary if the lagged effects of previous rate hikes were only recently starting to have an impact on overall consumption.

In summary, the decision to raise the interest rate was driven by the concerns surrounding inflation expectations, persistent excess demand, and strong consumer spending. The central bankers weighed different scenarios but ultimately opted for a rate increase to address the inflationary pressures and prevent the need for even more aggressive rate tightening in the future.

Canadian Economic Momentum Slows in Q2 Amidst Challenging Conditions

The Canadian economy, which started the year on a surprisingly strong note, experienced a deceleration in the second quarter. According to preliminary data released by Statistics Canada on July 28, the gross domestic product (GDP) contracted by 0.2 per cent in June, marking the first decline this year. This slowdown came on the heels of a 0.3 per cent expansion in May, which was in line with the expectations of economists surveyed by Bloomberg.

When considering the monthly gains from April to June, the data indicates an annualized growth rate of 1 per cent for the second quarter. However, this figure falls short of the Bank of Canada's earlier projection of 1.5 per cent growth for the same period. It is also significantly weaker than the robust 3.1 per cent growth witnessed in the first three months of 2023.

The moderation in economic growth was largely anticipated by Governor Tiff Macklem and his officials. They had foreseen an average growth rate of around 1 per cent throughout the latter half of 2023 and the initial half of 2024. Several factors were expected to contribute to this slowdown, including higher interest rates dampening household spending and business investment, as well as sluggish foreign demand amid a broader global economic deceleration that would constrain export growth.

The recent report by Statistics Canada supports these projections, indicating that the Canadian economy is indeed entering a softer phase. Until now, the economy had remained resilient despite previous interest rate hikes by the central bank. However, the growth in consumption spending is expected to taper off in the latter half of 2023 due to weakened demand for rate-sensitive goods and services. Moreover, as more households renew their mortgages at higher interest rates, discretionary spending may come under further pressure.

As the year progresses, it will be essential for policymakers to closely monitor economic indicators and adapt strategies accordingly. The moderation in economic growth and the challenges faced by certain sectors highlight the need for a cautious and data-driven approach to economic management. The Bank of Canada's actions and decisions in the coming months will play a crucial role in steering the Canadian economy through this softer patch and ensuring sustainable growth for the future.

The Week Ahead

It’s a relatively quiet week on the Canadian data front. Notable releases are as follows:

• Friday (8:30 AM) - July’s Employment Report