Bank of Canada’s inflation fight a necessary ‘kamikaze mission’ into recession: Desjardins

Desjardins Capital Markets is warning the Bank of Canada will be pushed into a “kamikaze mission” if it is intent on getting inflation back to its two per cent target.

In a note to clients Wednesday, Desjardins managing director and head of macro strategy Royce Mendes said that if the central bank is hell-bent on getting price pressures back to its range, the cost will be significant, especially as workers push for higher wages to combat the erosion of purchasing power.

“The only sure-fire way to contain that risk is to fly a kamikaze mission. Looking at US wage data, since Canadian numbers don’t go back far enough in time, it’s clear that recessions can break the cycle [of higher wages fueling inflation,]” he said.

Mendes said that Bank of Canada Governor Tiff Macklem and his colleagues have little choice to trigger such a recession if they hope to break the current inflationary cycle, where price pressures are running at more than three times the central bank’s target rate.

“To hit its inflation mark, the central bank has little choice now but to aim for a recession. A monetary-policy induced recession in Canada became our base-case forecast in early summer. Recent data releases, and the Bank of Canada’s reaction to them, have reinforced that view,” he said.

“While some shops are still debating whether or not a recession is on the horizon, we’re now wondering if it will only be a mild downturn.”

Canadian inflation has ticked modestly lower from its recent peak of 8.1 per cent – ​​largely due to a decline in gasoline prices – but still remains at 7.6 per cent, well above the central bank’s comfort range.

That’s led to the Bank of Canada warning of the potential for a so-called “wage-price spiral” where workers demand higher compensation, in turn putting more money in consumer pockets that will in fact fuel higher prices. While wages in Canada have not kept pace with inflation, they’re still running at about five-and-a-half per cent.

While Mendes and the Desjardins team still forecast a terminal rate – the point where central banks conclude their policy cycle of raising or lowering the cost of borrowing – at 3.75 per cent, he warned that there would be pain for recent homebuyers with a variable-rate mortgage.

“Even just a 3.75 per cent terminal rate spells trouble for these borrowers, with the monthly interest owed on the mortgage slightly exceeding the total fixed payment,” he said.

“That said, mortgages originated in September 2021 are far from the worst-placed to withstand the upturn in interest rates. Homebuyers that borrowed after September 2021 would have had even less time to pay down principal while rates were at rock-bottom levels.”

Desjardins has previously forecast that national home prices will decline 23 per cent from their February peak to the end of next year.

In spite of expecting more pain to come, Mendes said the central bank must remain resolute – and communicative – with Canadians about the policy path forward.

“Overall, expect central bankers to be more forthright in the coming months. They will need to both recognize the likelihood of a recession while also remaining resolute in their quest to conquer inflation despite that prospect.”

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