BANK OF CANADA HOLDS RATES, BUT IT WILL STILL DRIVE BORROWING COSTS HIGHER
Canada’s central bank didn’t break its pause, but signaled it will still drive borrowing costs higher. This morning, the Bank of Canada (BoC) announced the overnight rate will hold at 4.5%, surprising few. They did just announce a pause at the last meeting, so reversing course was unlikely. However, that doesn’t mean borrowing costs won’t rise further. The central bank reiterated it will continue quantitative tightening (QT), reducing credit liquidity.
Quantitative Tightening Is Like Quantitative Ease, But In Reverse
To understand quantitative tightening (QT), you first need to understand credit liquidity. A central bank helps manage inflation by influencing the supply and demand of credit. If inflation is too low, the key interest rate is lowered to incentivize borrowing. The goal is to intentionally overrun supply with new demand, driving inflation. Similarly, if inflation is too high, they raise rates to reduce demand, and drive prices lower.
When the key interest rate can’t move further, they turn to unconventional policy. If rates are too low but more liquidity is needed, they use quantitative ease (QE). QE sees the BoC competitively bid up the price of bonds, driving down yields and thus borrowing costs. By flooding the system with money, they reduce borrowing costs, sending investors elsewhere. This helps to lower costs even lower than rates, driving more demand, and inflation.
QT is the opposite of QE, reducing liquidity and increasing borrowing costs. The BoC reduces the bonds it holds by selling, or not replacing them after they mature. This reduces credit liquidity, typically driving borrowing costs higher. A disincentive to borrow and reduced leverage to cool demand and inflation. It does this without higher interest rates, impacting more targeted credit.
The Bank of Canada Is Still Reversing Its Massive Stimulus Injection
The BoC is now in the process of trying to reduce some of the epic stimulus it injected into the system. It used QE for the first time in 2020, increasing the balance sheet by nearly 5x to $575.3 billion in March 2021. That was the peak holding, and as intended—it helped flood the market with excess capital. Shortly after, a generational high for inflation appeared. Mission accomplished, but it might have been a little too effective, requiring undoing.
Interest rates didn’t rise today, but the BoC did emphasize it will continue to use QT. Since peaking, the balance sheet has been reduced by 33.6% as of the first week of March 2023. The reduction in 2023 has been particularly sharp, shedding 6.8 points in a little over a month. That would be a major contributor to bond yields rising all of a sudden from the end of January to March.
The BoC declared a “conditional pause” at the end of the last meeting, so it wouldn’t be a pause if they hiked today. They would look clueless by reversing course already. However, they emphasized they’re working to further reduce liquidity, and throttle credit. It’ll translate into higher borrowing costs, and further demand reduction without a hike.
Though the market is still pricing in another hike later this year.
Story by: Better Dwelling