Higher interest rates are coming. Omicron is unlikely to change that

U.S. central bank takes a firmer line on soaring inflation, and in some ways Canadians may feel the effects even more than their southern neighbours.

Canadian borrowers prepare as U.S. central bank warns of 3 rate increases in 2022

Jerome Powell, chair of the U.S. Federal Reserve, said that a powerful rogue variant of COVID-19 could shake up the central bank's plans to hike rates, but it appears Omicron is not that variant. (Al Drago/Bloomberg)

As Canada's federal government prepares for another encounter with COVID-19, Canadian borrowers must face a second hazard: the prospect of a sharp rise in interest rates in 2022.

While the world's most powerful central banker, Jerome Powell, warned on Wednesday that a new variant capable of smashing through vaccine defences could check the U.S. Federal Reserve's plans to cut stimulus, so far it appears Omicron is not that variant.

As yet, the Fed's interest rate remains unchanged at below one quarter of a per cent.

Major crackdown on inflation

But in what's being described as a major about-face to crack down on inflation, Powell announced the central bank will double the pace at which it slows its bond buying, leaving the Fed open to begin raising interest rates as soon as April.

And estimates by Fed officials who make monetary policy decisions are that the bank will raise interest rates three times in 2022, leaving room for other central banks, including the Bank of Canada, to do the same.

Asked whether the Omicron version of the COVID-19 virus now sweeping through the world could block the central bank's plans to roll back stimulus, Powell said that so far, his judgment was that the U.S. economy's vitality would not be diminished by the new variant.

A man gets a COVID-19 vaccine in Britain on Wednesday, where the new Omicron variant has swept through the population. Powell said the U.S. economy has learned to adapt to 'wave upon wave' of the coronavirus. (Hannah McKay/Reuters)

"The early assessment is highly transmissible, perhaps not as severe," he said. "It may well come to the United States and replace Delta as the dominant variant fairly quickly."

But after experience with the Delta variant, the Fed chair seemed confident the economic effect on the U.S. would be small.

"I do think wave upon wave, people are learning to live with this," he said.

And Powell said powerful job creation, a vibrant economy and soaring inflation mean the U.S. central bank has little choice but to end stimulus and crack down on inflation.

Fed plays catch-up with Canada

The Federal Reserve is only now catching up with Canada. At a news conference of his own earlier in the day, Bank of Canada governor Tiff Macklem, after saying he was uncomfortable with inflation at these levels, was asked why he didn't take action.

"We are taking action," Macklem replied briskly. "We tapered and we ended Q.E."

Quantitative easing, or Q.E., is another term for the stimulative bond-buying that the Fed is only now promising to end by spring. Despite a determination by the Canadian central bank to act independently from its larger counterpart in Washington, it can be difficult for the Bank of Canada to raise interest rates much before the Fed does.

Bank of Canada governor Tiff Macklem addressed the knotty problem of Canadian inflation at a news conference in Ottawa on Wednesday. (Blair Gable/Reuters)

When Canadian rates rise faster than those of the U.S., the move of hot money into the loonie pushes the Canadian dollar up, making Canadian exports more expensive around the world. A decision by the Fed to raise interest rates will free up Macklem to act as well without the worry of damaging Canadian export trade.

Inevitably rate increases by the Federal Reserve affect Canadian borrowers. The rule of thumb is that while the Bank of Canada's rate hikes affect short-term borrowing such as lines of credit, hikes in the U.S. rates have a bigger impact on longer-term loans such as mortgages.

In some ways, the impact of rising rates could hit the Canadian economy harder. Inflation here was unchanged at 4.7 per cent on Wednesday and really doesn't need as much discipline as in the U.S., where prices are rising at a rate of 6.8 per cent. And if rate hikes cause a drop in Canadian house prices, which on Wednesday hit another all-time high, that could have an impact on the wider Canadian economy.

As both central bankers said on Wednesday, the main cause of the current bout of inflation is a burst of spending on goods by consumers just as the supply was slowed by COVID-19 lockdowns at production facilities. That was followed by shipping bottlenecks as supply chains have struggled to catch up, perpetuating shortages and helping to drive prices up.

Rate hikes don't fix bottlenecks

One complication for both central bankers is that higher interest rates don't really solve that problem. In fact, the arrival of Omicron could actually worsen supply problems as people once again divert spending on trips and restaurant meals toward ordering more physical goods online.

But as high inflation persists, Powell and Macklem feel they need to cool things down before people just assume inflation will continue — what they call embedded inflationary expectations.

As Macklem said on Wednesday, "The challenge here is to bring inflation back to target without choking off the recovery."

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At the Federal Reserve news conference, reporters demanded to know why Powell hadn't acted more quickly and whether the fact that he had been waiting for his reappointment as Fed chair meant he had delayed cutting stimulus — even though inflation had clearly started to rise.

Powell denied that had been a factor, citing the sudden autumn shift in unemployment and economic growth that completely changed his outlook.

"We're coming out of what we certainly hope will be a once-in-a-lifetime, certainly historic ... first really global modern pandemic, which looked at the beginning like it might cause a global depression, so we threw a lot of support at it," Powell said, explaining how much things have changed.

"What's coming out now is really strong growth, really strong demand, high income," he said. "People will judge in 25 years whether we overdid it or not."

Follow Don on Twitter @don_pittis


Don Pittis

Business columnist

Based in Toronto, Don Pittis is a business columnist and senior producer for CBC News. Previously, he was a forest firefighter, and a ranger in Canada's High Arctic islands. After moving into journalism, he was principal business reporter for Radio Television Hong Kong before the handover to China. He has produced and reported for the CBC in Saskatchewan and Toronto and the BBC in London.