In 2020, with the economy the middle of an epic recession, Bank of Canada governor Tiff Macklem pledged to keep interest rates near zero for a couple of years. Now, with inflation well off the central bank’s target, investors should brace for a “hawkish signal” that rates will need to stay higher for longer to crush cost pressures, research firm Capital Economics warned.

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“The Bank of Canada is set to raise interest rates by a smaller 25 basis points next week,” Stephen Brown said in a note on Jan. 18. “While many will be looking for clues that this will be the end of the tightening cycle, the key risk to market pricing is that the bank sends a hawkish signal by including new forward guidance that it expects interest rates to remain high for longer than is widely assumed.”

Brown added: “We … think (the central bank) will add some guidance to its policy statement about the likelihood that interest rates will need to remain high for the rest of this year and potentially into 2024.”

Capital Economics is one of about a dozen research shops that regularly supply commentary on the Bank of Canada. Many of them predict the central bank will lift its benchmark interest rate a quarter point at its next policy announcement on Jan. 25, which would put the policy rate at 4.5 per cent. If they’re right, it would be the smallest increase since March, when Macklem began what would become the most aggressive series of interest rate increases in the central bank’s history.

But there is less agreement among Bank of Canada watchers about what will happen next.

Economist David Rosenberg, who is widely read on Bay Street and Wall Street, told an audience of Rosenberg Research and Financial Post subscribers on Jan. 19 that he thought central banks had already raised interest rates too high and that policymakers will be cutting rates sooner than most expect.

Others reckon the Bank of Canada will stop raising rates next week, and then keep markets guessing on what will come next. Veronica Clark, an economist at Citigroup Global Markets Inc., thinks the central bank will raise interest rates again in March as inflationary pressures persist.

Brown is the first to suggest that Macklem could opt for forward guidance, a tool that central banks use to convince the public that they are serious about achieving certain outcomes.

That’s not Capital Economics’ base case. The firm itself is closer to Rosenberg, predicting that slower economic growth will force the central bank to reverse course and cut interest rates.

But Brown is unsure that the Bank of Canada’s outlook will match his own. He said there remain many areas of vulnerability in the economy, among them business and consumer expectations of higher inflation, and that the central bank could fear loosening the leash on interest rates. This could prompt the central bank to signal at its next rate decision on Jan. 25 that higher rates could stick around, possibly into next year, Brown said.

Indeed, inflation sentiments among consumers and businesses remain elevated.

For example, the latest Bank of Canada Business Outlook Survey found that more than 40 per cent of businesses expect inflation to stay above the central bank’s two per cent target until 2026. What’s more, consumers’ inflation expectations rose from the third quarter to the fourth quarter of 2022. Respondents said they think a year from now, inflation will sit at 7.2 per cent. Their two-year expectations for inflation fell to 5.1 per cent, but that’s still well above Bank of Canada’s two per cent goal.

On Jan. 17, Statistics Canada said inflation for December slowed to 6.3 per cent year over year. November’s consumer price index was 6.8 per cent. The data agency said most of the decline in the headline number related to a 13.1 per cent year-over-year drop in the price of gasoline. There were also signs of slowing in other areas including appliances, automobiles and furniture.

“The bigger problem for the bank is that easing supply shortages and lower price gains have had little effect on inflation expectations,” wrote Brown.

Despite the possibility of a “hawkish signal” from the Bank of Canada, Brown said Capital Economics is sticking with its forecast of a rate cut this year, but has now pushed it out to September from July.

“Our own view is that the economy will weaken faster than the bank expects, and inflation will fall faster too, allowing it to start cutting in September,” Brown said in an email.

• Email: gmvsuhanic@postmedia.com | Twitter: gsuhanic