Inflation and Rate Hikes: The Year Ahead for the Canadian Economy

by Sri Thanabalasingam

After suffering a historic contraction in 2020, the Canadian economy rebounded in 2021, and is on pace to grow by 4.5% this year. Much of the gain in 2021 was seen in the second half of the year when provinces gradually lifted restrictions as vaccination drives ramped up across the country. Economic growth in the third quarter was 5.4%, a substantial improvement from the 3.2% decline observed in the second quarter. GDP growth is likely to remain solid to end the year given ongoing spending enthusiasm exhibited by consumers, and healthy hiring activity. However, flooding in B.C. will take some of the sheen off growth in the fourth quarter.

Unfortunately, 2021 wasn’t only a year of economic improvement, price pressures also started bubbling this year with inflation rising from 3.1% year-over-year in June to 4.7% in October. This is because the supply side of the economy has struggled to match the robust rebound in demand, which has resulted in higher prices. There are a few reasons for the supply side woes. For one, global supply chains have come under intense pressure as factories and shipping companies have not had the capacity to service the surge in consumer demand. In addition, the zero-COVID strategy pursued by some Asian countries led to a backlog of orders. This sent shipping costs skyrocketing, although they have moderated recently. Two, businesses in some industries have had trouble staffing new employees due to mismatches in the labour market. Early indications are that employers are beginning to increase wages to attract new workers. And three, extreme weather has led to an unexpected drop in global food production, thereby boosting food prices. With these factors still at play, inflation is on track to end 2021 at around 5% y/y, the highest inflation rate in Canada since the early 1990’s.

Looking ahead to 2022, the Canadian economy is expected to continue its streak of GDP gains while inflation remains elevated. On the GDP side, underpinned by nearly $200 billion in additional savings, and solid employment growth, consumer spending is likely to keep advancing at a stellar clip next year. Services consumption, especially in areas, that were under stringent restrictions through most of the pandemic period (i.e. travel, restaurants, entertainment activities), will see solid growth. Businesses are also likely to come off the sidelines in 2022, resuming investment plans that were shelved last year. This implies domestic demand conditions will be strong in Canada, which in turn means inflation will remain elevated next year. Indeed, even as aforementioned supply side disruptions ease, the economy will likely move above its productive potential in the middle of next year, generating additional price pressures. Consequently, inflation could run around 3.5% in 2022.

The full absorption of economic slack will satisfy the key condition the Bank of Canada had laid out in its forward guidance of monetary policy. Thus, interest rate lift-off will likely take place sometime in the middle of 2022. However, there are risks around this forecast. The labour market is on solid footing, and there are signs that inflation expectations are moving higher. The Bank may want to get ahead of this by hiking rates earlier. There is also the Omicron variant, which could exacerbate price pressures if it turns out to be a nastier strain than Delta. The Bank has promised to do a full assessment of inflationary forces ahead of its January decision, which could be used to set the stage for the first interest rate hike, possibly as early as March.  From there, the overnight rate is likely to be increased methodically to 1.25% by the end of the year as the Bank seeks to gradually remove monetary stimulus.

That being said, let’s be clear, we are still living through a pandemic, and the emergence of new variants could send shockwaves through the economy. Hopefully, 2022 is the year we see a longer-term solution to the health crisis. Fingers crossed.

Sri Thanabalasingam is a Senior Economist at TD.

This article is re-published from the Winter 2021 issue of “Street Talk”, TiF’s flagship publication. Interested in writing for us? Click here for our submission guidelines.