Shoppers are starting to return to downtown Montreal as the country rolls out its Covid-19 vaccination programme. Meanwhile, the Bank of Canada is considering increasing interest rates in 2022 rather than 2023

Alfred Romann, journalist based in Canada

After something of a sluggish start, Canada is quickly vaccinating people against Covid-19 and starting to open its economy. It is looking like the summer could be reasonably, if not totally, normal.

With expectations that the economy will reopen, the Bank of Canada (BoC) became the first central bank in the G7 to take steps towards moving away from pandemic stimulus footing.

If inflation gets out of control and rates rise further and faster than expected, borrowing will become much more expensive – and so will everything else

This happened in April, when the economy contracted by 0.8%. Still, in the midst of that contraction the BoC was optimistic. It later boosted its growth forecast for 2021 by more than 2% to 6.5%, and added expectations for 3.7% growth in 2022 and 3.2% in 2023.

Cutting back

The BoC has started cutting back purchases of government debt, down to about CA$3bn per week. The bank also moved up its timeline to begin increasing interest rates, possibly in the second half of 2022 and not in 2023 as originally thought. The volume of asset purchases will likely fall again this year.

Inflation went up in April, but that was not surprising given that economic activity has been very subdued for more than a year. The increases in inflation are not expected to hold, but volatility is, particularly because businesses (and not a few stock market investors) are now hyper-sensitive to any suggestion that rates could start inching up sooner rather than later. And central banks have, traditionally, raised rates to bring inflation down.

Economic chicken

Canada is hardly the only country in the world playing economic chicken with higher rates.

Stock market investors in the US have had several tantrums over the possibility of the US Federal Reserve raising its ultra-low rates as soon as the end of next year. The Fed has said that it will probably not begin considering raising rates until the country hits full employment, and that could be some time yet. Employment growth in April was disappointing but private jobs growth in May was the fastest in about a year.

Something similar is happening in Europe. Fears that central banks would lift rates sent bond yields higher over the past couple of months, but the inflation outlook has remained subdued. As of early June, the European Central Bank had said little about cutting back on bond purchases or showed any hurry to raise rates, despite some members' comments.

There are many who think that the BoC will hold off on raising rates. But there is no getting away from the reality that the stage is set for a significant economic rebound, and that can translate into inflation, which is often controlled with higher rates.

Concerns remain

But even as the economy rebounds, concerns remain.

Besides inflation, there are worries about underemployment if people who lost their jobs during the pandemic choose to not return to the workforce; even if they are a minority, they could have a significant impact on the country’s labour market.

Businesses should be prepared to adapt to the changes that lie ahead. Some will be good, like the widely anticipated return to in-store shopping and restaurants operating at fuller capacity. Others will be more problematic, including the likelihood of higher rates and more expensive costs of borrowing after years of cheap and plentiful capital.

Small and gradual increases in interest rates are not likely to have much of a negative impact on the real economy, regardless of what stock markets say. But if inflation gets out of control and rates rise further and faster than expected, borrowing will become much more expensive – and so will everything else.