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Will hot inflation cause a January Bank of Canada rate hike?

Earlier this month, the Bank of Canada indicated that it may be close to finishing its rate hiking cycle, stating in its December 7 rate announcement that its Governing Council will consider whether interest rates will need to rise further, rather than explicitly stating they would, as they have in previous announcements.

This shift in tone has created optimism among economists (and borrowers!) that rate relief is on the way… but the latest set of inflation data may throw a wrench in those plans.

The November inflation reading from Statistics Canada reveals the Consumer Price Index (CPI) rose 6.8% year over year in November, a scant decline from the 6.9% growth recorded in October. The small drop is largely due to lower gas prices, which fell 3.6%. The cost of groceries, however, continued to rise 11.4%, putting even more pressure on shoppers’ wallets. 

As well, core inflation – a measure of the cost of goods and services with food and gas prices stripped out – rose by 5.4%.

This is the exact opposite of what the Bank of Canada wants to see; the central bank has been hiking its trend-setting Overnight Lending Rate since March to combat the sharp pace in inflation growth, bringing the benchmark cost of borrowing from a pandemic low of 0.25% to 4.25% today.

Higher interest rates influence inflation by taking the steam out of consumer demand – when costs are higher, shoppers and borrowers spend less, thereby reducing the pace of price growth and the overall economy. Bank of Canada Governor Tiff Macklem has stated in the past that the economy must chill before they’ll put an end to rate hikes.  

This new data could set the stage for one more increase in the new year. According to an analysis written by Derek Holt, President and Head of Capital Markets at Scotiabank Economics, “[The] key here is that traditional core inflation remains well above the BoC’s target and that keeps hike risk alive into the January meeting.”

“We’re off the peak from earlier in the year but these are not cool numbers by any stretch. In any world other than the pandemic the BoC would be freaking out over core inflation readings that are still doubling its target,” he writes.

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Why is inflation important to the Bank of Canada?

The Bank of Canada’s main mandate is to keep the economy – and the Canadian dollar – stable. A key element of this is the pace of inflation; when it runs too hot, it destabilizes the economy by making consumer goods too expensive, along with the cost of business. The Bank of Canada strives to keep inflation growth within a range of 2%. When the pace of CPI exceeds this boundary, it must react by increasing its Overnight Lending Rate, which consumer banks use to set the floor for their Prime rates (which in turn are what variable-rate mortgages and HELOCs are based on).

Canada’s inflation rate has been quite volatile over the course of the pandemic. In January 2020 – before the economy was impacted by COVID-19 – the inflation rate was 2.4%. It then plummeted during the following lockdowns, falling to 0.7% by the end of that year. However, it swiftly ramped back up over the course of 2021 as lockdown measures eased and businesses re-opened. Snarled supply chains and labour shortages have also contributed to the sharp uptick in the prices for consumer goods, energy, and food.

Inflation surpassed 5% for the first time in January 2022, which set off alarm bells among economists that steep rate hikes would soon be on the horizon. However, the Bank of Canada didn’t start to address it until March, when it kicked off the first of what would be seven rate hikes to date. The impact of those hikes didn’t start to take hold until this summer; inflation hit a 40-year high of 8.1% in June, before starting to ease down slowly. 

In total, the pace of inflation has increased 6.1% between the end of 2020 and today, while the Bank of Canada rate has increased a total of 4%, from 0.25% to 4.25%.

What does this mean for borrowers?

If the Bank of Canada hikes the Overnight Lending Rate again in its January 25th announcement, borrowing costs will increase for variable-rate mortgage holders.

Borrowers who have a variable rate with variable payments – meaning the amount they pay is directly tied to their bank’s Prime rate and fluctuates along with the Bank of Canada's rate – will immediately pay more for their mortgage on a monthly basis.

Borrowers with a variable mortgage that has fixed payments – meaning they stay the same each month regardless of what happens to the Prime rate – will see more of their payment go towards their interest costs rather than their principal debt. They may also be more at risk of hitting their trigger rate (the point when their payment only covers interest) if they haven’t done so already. This will prompt a phone call from their lender to discuss their options, which could include extending their amortization, refinancing their mortgage or making a lump sum payment.

Fixed mortgage rate holders with existing mortgages will not be immediately impacted by another Bank of Canada increase.

The bottom line

Variable-rate mortgage holders should brace for the possibility that their debt servicing costs may rise at least one more time in the short term.

For those wondering what their next move should be in today’s rate environment, it’s always a smart idea to get expert advice from a mortgage broker, who can assess your personal mortgage situation and discuss your options at no cost to you.

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