The Bank of Canada is on the horns of a dilemma. It must either push the economy into recession, or risk tanking its own credibility on inflation by cutting rates sooner, rather than later.
In a new report, economists at TD Bank say the central bank has a tough road ahead this year, as it faces the prospect of reversing course on interest rates, even as inflation continues to run hotter than it would like.
“The central bank will have to cut interest rates in the face of stubbornly high shelter costs because to neglect to do so risks running the economy aground,” the report said.
Indeed, keeping rates “higher for longer” would more or less ensure a recession, it said.
Alongside heightened recession risks, the central bank may also be tempted to cut rates, given the intensified financial stress that accompanies higher rates, and the signs that the sources of inflation are narrowing, it suggested.
However, if the bank starts cutting rates to avoid these mounting economic and financial risks, this could also stoke household inflation, the report warned.
“So, the challenge for the Bank of Canada will be twofold. It will need to trust the process and start cutting interest rates before inflation is comfortably at target, while also successfully convincing the public that it knows what it’s doing,” it said.
At the heart of this challenge is the fact that housing costs will likely remain elevated amid a large, persistent supply-demand imbalance.
“There’s not much the Bank of Canada can do to address a structural shortage of housing. That responsibility falls into the lap of governments to ensure specific policies related to population growth have parallel housing supports,” the report said. “But the Bank of Canada is charged with anchoring inflation expectations around its 2% target, which is made more difficult by this challenge.”
As it stands, shelter costs are contributing over half of headline inflation, and that share is set to grow as prices in other sectors cool, the report noted.
So, cutting rates while a major source of inflation stays hot will likely require a deft pivot in the Bank of Canada’s communications strategy, “to emphasize that shelter costs do not define broader inflation trends in Canada,” the report suggested.
“The stars won’t be perfectly aligned on the inflation front relative to the timing of when interest rate cuts will need to commence. And this could create a huge communication challenge for a central bank that may already have a credibility problem on its inflation-fighting credentials on main street,” it said.