U.S. inflation could push Bank of Canada to move policy rate higher than 4%

Canada could get a cold if the US sneezes. Economists are looking over this week's U.S. consumer price index readings and pondering how they might push the Bank of Canada to get tougher in its fight against inflation.

The growth of the U.S. consumer price index slowed in August to an annual rate of 8.3 per cent, down from 8.5 per cent in July but still higher than the 8.1 per cent economists were expecting. The release sent stocks plunging the most since 2020 and have prompted economists on both sides of the border to revise their rate-hike expectations for the rest of the year.

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"Hotter U.S. inflation that drives aggressive Fed tightening and weakens the Canadian dollar is likely to motivate the Bank of Canada to have greater confidence to shoot past four per cent with its policy rate." The data out of the U.S. could embolden Canada's central bank to move more aggressively to fight inflation.

If not October, the Bank of Canada is likely to be dragged along by the Fed with domestic fiscalStimulus reinforcing the likelihood of the policy rate breaching 4% by December.

The terminal rate, the maximum rate the central bank is expected to hit in its rate-hiking cycle, has been moved by economists at the Toronto-Dominion Bank. It was plausible that a terminal rate as high as 4.5% was also possible.

The Bank of Canada will be influenced by how inflation plays out at home. The headline inflation figure for July was below the eight per cent mark due to falling gasoline prices. Inflation figures for Canada are due next week.

Wage growth can lead to faster rate hikes. Carolyn Rogers told reporters last week that this was one of the factors the Bank would be keeping a close eye on as employees request higher wages or seek higher paying jobs to keep pace with the rising cost of living. She warned that a wage-price spiral could happen if wages go up too much.

The dynamic was pointed out in a Sept. 14 note to clients by the managing director and head of macro strategy at Desjardins. The Bank has little choice but to aim for a recession in order to avoid the "nightmare scenario" of high inflation.

It is the only sure-fire way to contain the risk. The data shows that a recession can break the cycle.

The odds of a recession in the U.S. have increased considerably, and Fed officials would be less inclined to pump the brakes on the current rate-hiking cycle.

If the U.S. enters into a mild downturn, Canada could avoid a recession. With central bankers north of the border continuing to aggressively hike interest rates, that is not likely to happen today.

It is possible that the economists at Desjardins will have to increase the terminal rate if the central bank becomes more aggressive in its monetary policy.

In an interview with Larysa Harapyn, Beata Caranci said it was possible the Bank of Canada would have to move higher than the Fed.

Caranci said, "Canada is certainly on the upper end of what we're seeing from some major peers." It is possible that we will have a Bank of Canada that has to hike to a higher level than what you are going to see out of the U.S.

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