The Bank of Canada will announce the conclusions of its latest round of policy deliberations on Jan. 25 at 10 a.m. eastern time. The safe bet is that governor Tiff Macklem will green light a quarter-point increase, which would lift the benchmark rate to 4.5 per cent and extend the most aggressive series of rate hikes in the central bank’s history.

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Most analysts predict policymakers will then decide that’s enough and stop. But that’s not guaranteed.

David Rosenberg, a widely read Bay Street economist and contributor to the Financial Post, thinks the Bank of Canada and its peers have already raised interest rates too high, creating the conditions for a recession that has already begun. If Macklem and his deputies have been reading Rosenberg, they will be reluctant to push borrowing costs higher.

Yet inflation — now around six per cent — remains well off the Bank of Canada’s target of two per cent. Cost pressures are receding, but perhaps not fast enough for an institution that’s mandated to achieve price stability. In other words, the Bank of Canada’s credibility is at stake. That’s one reason most of the professionals who are paid to predict the trajectory of Canadian interest rates say Macklem will raise the benchmark rate at least one more time. Citigroup Global Markets Inc.’s Veronica Clark thinks it will take a hike this week and one more increase in March to get inflation under control.

This week’s policy decision will be a pivotal moment in Macklem’s battle with inflation. Here’s what you need to know:

Data dependency

The Bank of Canada’s decision to lift the benchmark rate by a half-point in December was classified as a surprise because Bay Street had settled on a smaller quarter-point increase as the most likely outcome. By opting for yet another outsized increase (central banks generally prefer quarter-point moves up or down), Macklem showed he will err on the side of crushing inflation when looking at a dashboard of mixed signals.

Despite the increase, however, the central bank said the game had changed. Policymakers opted against raising interest rates in January 2022, but they did emphatically state that they would be raising the benchmark rate when they updated policy five weeks later. They followed through, locking in a sequence of policy meetings where the only question under consideration was how high? With headline inflation on its way to a June peak of 8.1 per cent, the Bank of Canada’s leaders knew they would be spending most of the year playing a high-stakes game of chase.

By the end of the year, Canada’s inflation fever seemed to be breaking. As policymakers administered another dose of tough medicine, they said they would be open to giving their patient a break in the new year.

“We indicated that going forward, we will be considering whether to increase rates further,” deputy governor Sharon Kozicki said in a speech on Dec. 8. “By that, we mean we expect our decisions will be more data-dependent.”

Macklem’s dashboard

The data published since early December are mixed. Year-over-year increases in the consumer price index slowed to 6.8 per cent in November (from 6.9 per cent in October) and then 6.3 per cent in December. By itself, that might be enough to persuade Macklem and his deputies to stop raising interest rates.

But the central bank started raising interest rates aggressively because it concluded demand had outstripped the Canadian economy’s ability to keep up, creating a mismatch between supply and demand that can only lead to inflation. Canada’s economy still had lots of heat at the end of the year. Employers added more than 100,000 jobs (dropping the unemployment rate to five per cent, one of the lowest marks on record), and retail sales and restaurant visits were buoyant.

Economists who doubted inflation could be tamed without a spike in unemployment are now eating their forecasts. “Underlying inflation does seem to be moderating without a recession,” Douglas Porter, chief economist at Bank of Montreal, told the Financial Post’s Stephanie Hughes. “My odds that I’m putting on a soft landing have been slowly rising over the last three months.”

The central bank will have been unsettled by its latest quarterly surveys of businesses and consumers. Both showed confidence waned in the fourth quarter, but that isn’t what will have bothered policymakers. Forty per cent of respondents to the Business Outlook Survey said it will take until 2026 or later to get inflation back to two per cent, and most consumers said they thought inflation would be around five per cent in two years. Those results suggest inflation is becoming a self-fulfilling prophecy, something Macklem has been desperately trying to avoid.

Why Macklem might keep going

Headline inflation is coming down, but core measures that correct for volatile prices such as gasoline are stickier. For example, Statistics Canada’s consumer price index, excluding food and energy, increased 5.3 per cent from December 2021, only a slight drop from 5.4 per cent in November. Commodity prices caused the initial surge in prices, but the main driver now is a combination of demand, expectations and the lagging effects of contracts signed when inflation was peaking last year.

“There’s not enough evidence to confidently say that inflation is clearly on its way back to the two per cent target,” Royce Mendes, an economist at Desjardins Group, said in a note.

The central bank doesn’t like to admit it, but its policy choices dictate the mood of the housing market. The spike in borrowing costs has hit the housing industry hard, although builders and mortgage brokers have been riding a wave of irrational exuberance for years. Housing markets are finally starting to look affordable. A decision to pause could cause the Bank of Canada to look weak, and reinforce bets in the bond market that policymakers will be cutting interest rates before the year is over.

“The BoC needs to consider that its actions could inflame future risks to housing affordability all over again,” Derek Holt, an economist at the Bank of Nova Scotia, said in a note last week.

Why Macklem might pause

The Bank of Canada will also update its economic outlook this week. Its October quarterly outlook had inflation averaging 7.1 per cent in the fourth quarter. Instead, year-over-year increases in the consumer price index averaged 6.7 per cent. Policymakers are gaining ground faster than they thought they would. Rather than add to the risk of a recession with another increase, it might be time to take stock, and maybe even hint at a declaration of victory.

Monetary policy works with a lag, so we haven’t yet seen the full effect of higher interest rates. Rosenberg thinks it could be ugly, given Canadian households piled up so much debt chasing sky-high housing prices over the past decade. Many of them will now be using more of their disposable income to pay higher debt-servicing costs instead of contributing to demand. Macklem doesn’t want to be remembered as the governor who let inflation off its leash, but he won’t want to be known as the central banker who caused a painful recession either.

“While labour markets remain very tight, inflation has come in cooler than expected in recent months and the housing market is still struggling,” the economics team at National Bank said in their latest weekly review of economic conditions. “As such, we’d argue that the prudent approach is to remain on the sidelines at this juncture, but we concede that this decision could easily go either way.”

Bottom line

There’s a good case for stopping. Elevated levels of debt and years of ultra-low interest rates have probably made the economy super sensitive to higher borrowing costs, meaning the pain is coming. But the data since December don’t appear to have satisfied the Bank of Canada’s own criteria for a pause. Kozicki said the central bank would need to see definitive evidence that inflation was headed back to target.

The stickiness of core prices, and evidence that a significant number of businesses and consumers expect price pressures to continue suggest inflation could stop falling before it gets to two per cent. That will concern policymakers the most. They care about growth, but at the end of the day, their mission is to get inflation back to two per cent. We’re still a long way from that.

• Email: kcarmichael@postmedia.com | Twitter: carmichaelkevin