By Fergal Smith
TORONTO (Reuters) - Bank of Canada Governor Tiff Macklem is likely signing up for inflation running above target as he seeks an economic recovery that raises prospects for everyone, making Canada's central bank just as dovish as the U.S. Federal Reserve, say economists.
Earlier this month, Macklem said the harsher and more prolonged economic impact of the novel coronavirus pandemic on lower-income workers, women and youth could slow the recovery and make it less durable.
The BoC has pledged to keep interest rates near zero until inflation is sustainably at its 2% target. If the central bank sees an inclusive recovery as key to achieving that goal, it could surprise financial markets by continuing to support the economy as it returns to its full potential, rather than dialing back to avoid above-target inflation, analysts said.
Hotter-than-expected inflation tends to raise the rate of return demanded by bond investors.
The Bank of Canada is "committing to an inflation overshoot," said Royce Mendes, a senior economist at CIBC Capital Markets. "The market doesn't seem to have grasped that in Canada as they have in the U.S."
Money markets see about a 50% chance that the Bank of Canada will hike interest rates in 2022. That is much earlier than expected by the Federal Reserve, which unveiled last month a new monetary policy strategy which would aim for inflation to rise above target for some time, making up for past shortfalls.
FOCUS ON INEQUALITY
Also, Canada's yield curve is not nearly as steep as the U.S. curve. A steepening curve, when long-term rates climb further above short-term rates, is seen as a sign of rising inflation expectations.
Higher prices tend to hurt lower-income workers the most, but central banks are trying to generate inflation that is driven by rising economic activity rather than reduced supply.
People's purchasing power is not going to be eroded by inflation because "wages are likely to be higher first and probably more so," Mendes said.
Monetary policy that takes account of inequality would complement the goals of Prime Minister Justin Trudeau's Liberal Party government. Trudeau is scheduled on Wednesday to unveil what he says is a bold far-reaching plan to help Canada recover from the coronavirus pandemic.
The government and the Bank of Canada are due next year to renew their agreement on Canada's inflation control target. For nearly three decades, they have determined that the best way for the central bank to maximize the economic well-being of Canadians is to focus on a target of 2%.
With Ottawa shifting toward a more activist fiscal policy and Macklem appearing to support a greater focus on addressing inequality, "that could soon change," said Stephen Brown, a senior Canada economist at Capital Economics, in a research note.
"The implication would likely be that interest rates are kept lower for longer, and periods of inflation above 2% are tolerated to achieve other objectives," Brown said.