Bank of Canada's rapid rate hikes likely to cause a recession, study finds

The Bank of Canada's strategy of rapidly increasing its key interest rate in an effort to tackle skyrocketing inflation will likely trigger a recession, says a new study released Tuesday from the Canadian Centre for Policy Alternatives (CCPA).

The study showed that in the last 60 years the central bank has in three cases managed a 5.7 per cent reduction in the inflation rate by quickly raising interest rate, and each case was followed by a recession.

The research institute said if the central bank aims to bring inflation down from 7.7 per cent to its two per cent target by quickly raising rates, it could cause significant "collateral damage," including 850,000 job losses, and is calling for a new policy on inflation targeting to reduce that risk.

Jennifer Lee, senior economist at BMO Capital Markets, who is expecting a 0.75 percentage point interest rate increase from the Bank of Canada this month, said the swift and aggressive hikes will "for sure" cause a significant slowdown in economic growth.

"Whether or not it's going to be an official recession remains to be seen, but clearly a significant slowdown," she said.

She also said there are few alternatives that the central bank has at its disposal right now to tackle inflation.

"Rate hikes are needed right now -- larger ones -- to slay this inflation monster sooner rather than later," she said.

David Doyle, head of economics at Macquarie Group, who is also expecting a 0.75 percentage point hike, is forecasting a recession in 2023 in both Canada and the United States.

"We expect the contraction to be greater in Canada due to its more severe structural imbalances, such as housing investment and consumer debt levels," he said.

Canada is already experiencing a slowdown in economic growth and even seeing layoffs in some sectors, like technology.

Statistics Canada said last week it expects to report a GDP contraction of 0.2 per cent for the month of May amid weakness in the resource, manufacturing and construction sectors.

In its study, the CCPA said the Bank of Canada could potentially reduce the risk of sending the economy into a recession by adjusting its target inflation rate to four per cent. The study highlighted how the bank has successfully avoided a recession when it has aimed for smaller reductions in inflation, allowing the bank to bring in smaller rate increases over a longer period.

However, Doyle said raising the inflation target to four per cent would be a "bad idea."

"It would damage the Bank of Canada's credibility and independence and create more uncertainty," he said. "It would also increase the risk of a severe downside scenario, where there is a de-anchoring of consumer and business inflation expectations."

The CCPA study comes a day after the Bank of Canada released two quarterly surveys which revealed consumers and businesses expect inflation to stay high for several years, further increasing the odds of a 0.75 percentage point interest rate hike this month.

While speaking to reporters at an event in Brampton, Ont. on Tuesday, Deputy Prime Minister Chrystia Freeland was asked about the CCPA study and said the Bank of Canada is well-equipped to handle the inflation problem.

"It has the tools and it has the expertise to (bring down inflation). And I think we should all have confidence that the Bank of Canada will do its job," she said.

As for how long it might take to even reach the central bank's two per cent inflation target, BMO's Lee said we'll likely see three per cent inflation by end of the 2023, with two per cent more a 2024 or 2025 possibility.

This report by The Canadian Press was first published July 5, 2022.