Rate Pause Expected from Bank of Canada Amid Energy-Led Inflation Pressures
The Bank of Canada is expected to hold interest rates steady this week while striking a more hawkish tone in its communications amid a surge in global oil prices that has reignited concerns about inflation.
The price of a barrel of crude has risen more than 40 per cent over the past two weeks, as the war in the Middle East has largely closed the Strait of Hormuz, through which around a fifth of global oil supplies typically travel.
That’s pushed up gasoline prices and airfares in Canada, and could increase the price of food and other products, particularly if the conflict between the United States, Israel and Iran stretches on through March and into April.
Central banks tend to look through this type of commodity price shock when setting monetary policy, and the Bank of Canada is widely expected to leave its benchmark interest rate at 2.25 per cent on Wednesday for the third consecutive time.
At the same time, economists expect Governor Tiff Macklem to signal that the bank is monitoring the situation closely and is prepared to adjust interest rates if necessary. Having let inflation get out of control in 2021 and 2022, central bankers are more sensitive today about the potential for supply-side shocks to become entrenched in a broader inflationary process.
“They’re going to have to sound more hawkish in the sense of saying, ‘If we see any of this becoming broad-based and there’s a move up in [inflation] expectations, then we might hike,’” said Paul Beaudry, a former Bank of Canada deputy governor and an economics professor at the University of British Columbia.
When dealing with this kind of price shock, you want to “get in front of the curve of having inflation expectations start to de-anchor,” Mr. Beaudry said, referring to a situation where businesses and households expect prices to rise quickly.
Before the outbreak of war in the Middle East, Canada’s central bankers had indicated that further interest rate moves, in either direction, were unlikely any time soon.
With inflation mostly under control, and the economy on track for slow but positive growth, they suggested the bank could stay on cruise control while it waited for the outcome of negotiations over the North American free-trade pact, slated for mid-2026.
The oil price shock doesn’t fundamentally change the economic picture in Canada, at least in the near-term, said Olivier Gervais, director of modelling and forecasting at Bank of Nova Scotia, and former director of Canadian economic projections at the central bank.
Higher oil prices boost Canadian exports, oil company profits and government tax and royalty revenues. But the impact of all this on the real economy has to be weighed against consumers being squeezed at the gas pump and having less money to spend elsewhere.
And a slew of recent economic data – including disappointing trade numbers and a weak labour market report released Friday – suggest the Canadian economy continues to struggle.
From a monetary policy perspective, however, the oil price shock means the central bank will be less worried about potential downside risks to inflation from weak economic growth, Mr. Gervais said.
“Central banks are trying to be risk managers at the end of the day, and this whole spike in oil prices removed a lot of the negative risk on inflation,” he said. “Now people are more worried about upside risks and I think the bank will communicate that.”
Financial markets have anticipated this shift in sentiment, and have moved from expecting no interest rate changes in 2026, to pricing in a hike in the back half of the year, according to Bloomberg data.
The latest inflation reading for January showed a 2.3-per-cent annual increase in the consumer price index (CPI). This number is sure to rise in the coming months, both because of the jump in oil prices, and because Ottawa’s removal of the consumer carbon tax last April – which has pulled down the annual inflation number – will drop out of the year-over-year inflation calculation.
“You’d be talking about probably slightly above 3 per cent in terms of headline inflation, and of course that is above the Bank of Canada’s 1- to 3-per-cent inflation control target range,” said Josh Nye, senior economist at RBC Global Asset Management.
The big question is how long the war continues and how long oil prices stay elevated, Mr. Nye said. The longer the energy market disruption, the bigger the risk that price pressures will migrate beyond gasoline and into a broader set of goods and services.
There’s also the risk that the gas pump sticker shock feeds into broader consumer and business inflation expectations. Rising inflation expectations can become a self-fulfilling prophecy, as companies raise prices ahead of expected cost increases and individuals demand higher wages.
“I’d certainly say that central bankers are more acutely aware of these second-round effects now than they were, say, five years ago, having gone through the experience of the pandemic, and then the oil price shock of 2022 – both supply-side shocks,” said Bradley Saunders, North America economist at Capital Economics.
But that doesn’t mean that the Bank of Canada is about to pre-emptively raise interest rates in response to today’s oil price shock, he said.
The situation is much different than it was in 2022, when Russia’s invasion of Ukraine caused a spike in oil and other commodity prices. At that time, inflation was already heating up, unemployment was low, the central bank’s policy rate was near zero and fiscal policy was highly stimulative. Caught on its back foot, the bank started raising interest rates rapidly in the spring of 2022.
Today, inflation is near the central bank’s target, monetary policy is in a neutral setting, and there is plenty of slack in the economy alongside elevated uncertainty over the future of the North America free-trade agreement. In that environment, a commodity price shock is less likely to feed broader inflationary pressures.
“In terms of the lessons for the Bank of Canada, I think we can learn a lot from how the bank responded a decade ago from 2010 to 2014,” Mr. Saunders said.
While the price of oil rose significantly over that period, core inflation was under control, the bank estimated that there was slack in the economy and it was worried about the eurozone debt crisis.
“All three of those factors urged policymakers to act with caution” and not raise interest rates, Mr. Saunders said. “I think those three all very much hold today and I think that’s a far better point of comparison than 2022.”
This article was first reported by The Globe and Mail
