Bank of Canada increases rates

A rate hike when underlying inflation is close to 2%? That is what makes today’s Bank of Canada decision interesting.

The Bank increased its policy rate by 25 basis points to 2.50%, its first increase since 2023.  

What makes this interesting is that underlying inflation is still relatively contained. Headline inflation has been around 3% since April, largely reflecting higher energy prices. Excluding gasoline, inflation was 2.2% in September, and core measures remain close to 2%.

So why raise rates?  

The concern is that sustained higher energy and import costs do not stay contained. Higher fuel prices are already raising production and transportation costs, while imported industrial and electronics input prices have also increased. Businesses have absorbed much of those higher costs so far, but the Bank expects more of them to be passed on to customers. In other words, the Bank is effectively trying to stop a cost shock from becoming a broader inflation problem.

That creates an uncomfortable combination for households: the possibility of higher prices and higher borrowing costs. Higher borrowing costs are landing when many households have limited room to absorb another expense. Canadian households were already directing 14.5% of disposable income to required debt payments in Q2, while the household saving rate was just 3.7%. This is the opportunity cost of higher rates: every additional dollar devoted to servicing debt is a dollar that cannot be spent or saved elsewhere

For small businesses, there are two sides to the squeeze. Their own borrowing and input costs are rising, while some of their customers have less discretionary income to spend. That makes passing higher costs on to customers more difficult, even as the pressure to do so increases.

I will be watching three things closely: whether energy and import costs spread into broader prices, whether businesses increasingly pass those costs through, and whether short term inflation expectations continue rising.

So today's 25 basis points is a hit. But the real vulnerability is what happens next. Every increase leaves stretched household and business budgets with less room to absorb another one.

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