This is an account of the deliberations of the Bank of Canada’s Governing Council leading to the monetary policy decision on July 12, 2023.

This summary reflects discussions and deliberations by members of Governing Council in stage three of the Bank’s monetary policy decision-making process. This stage takes place after members have received all staff briefings and recommendations.

Governing Council’s policy decision-making meetings began on Wednesday, July 5. The Governor presided over these meetings. Members in attendance were Governor Tiff Macklem, Senior Deputy Governor Carolyn Rogers and Deputy Governors Paul Beaudry, Toni Gravelle, Sharon Kozicki and Nicolas Vincent.

The international economy

Governing Council began by discussing recent global economic developments. Overall, the global economy was stronger than had been expected at the beginning of the year. While growth had slowed, consumer and business spending was resilient, particularly in the United States. Headline inflation had fallen in most advanced economies largely because of lower oil prices and easing goods price inflation.

Governing Council reflected on some common themes that were evident across advanced economies:

• Measures of core inflation had proven to be stubborn due to robust consumer demand, tight labour markets and elevated inflation expectations.
• Supply bottlenecks were largely resolved and manufacturing was slowing as the demand for goods weakened, but demand for services remained strong.
• Despite substantial tightening of monetary policy over the past year, underlying inflation pressures had proven to be more persistent, leading major central banks to signal that further tightening may be needed to tackle inflation.

Members noted that economic activity in the United States was stronger than expected in large part due to surprisingly robust consumer spending. US households benefited from a strong job market that fuelled income growth, and they continued to draw down their accumulated savings.

Growth in the euro area essentially stalled in the first half of 2023 due to weak consumer demand for goods and tighter monetary policy. At the same time, the services sector remained resilient partly in response to pent-up demand.

Members talked about how the Chinese economy was projected to slow by more than previously expected after a strong rebound in growth following the lifting of pandemic restrictions. Slower global growth weighed on manufacturing and exports, and the Chinese property sector remained weak. This slower growth in China has implications for both oil prices and demand for non-energy commodities.

Governing Council noted that oil prices had declined since the last projection, but they could rise again if supply does not keep up with global demand over the projection horizon. The voluntary production cuts announced by several members of the Organization of the Petroleum Exporting Countries (OPEC) and some non-OPEC oil producers to constrain global supply may outweigh potential softness in demand largely coming from slower global growth and a greater-than-expected slowdown in China.

Governing Council agreed that the risk of an emergence of global banking strains had diminished but had not gone away. Yields on government bonds in Europe and North America had increased, while equity prices had been stronger overall since June.

The Canadian economy and inflation outlook

Governing Council members continued their discussions from the previous decision in June and reviewed the evidence that had accumulated over the last few months about the Canadian economy and the dynamics for inflation.

Members revisited their assessment of the surprisingly strong growth in consumer spending in the first quarter of 2023. They agreed that while many factors could have contributed to this strength, the following were likely to be most important:

• Tight labour markets and solid income growth were supporting spending.
• Additional savings accumulated by Canadians through the pandemic were providing a buffer for higher prices and interest rates.
• Strong population growth surged in the first quarter, adding to consumption.
• Pent-up demand, especially for services, continued to boost consumption as more Canadians caught up on activities they could not participate in during the pandemic.

Governing Council discussed whether this strength in consumer spending was likely to persist in the near term. On one hand, the strong first quarter of 2023 followed weak consumption growth in the second half of 2022, which could indicate a temporary bump due to the timing of the delivery of some durable goods. Pent-up demand for services should also wane over time. On the other hand, retail trade data for April indicated ongoing demand for goods. These data were signalling growth in the second quarter for most interest-rate-sensitive sectors outside of motor vehicles. In addition, housing prices picked up as demand for housing continued to outpace supply.

Governing Council spent time discussing the impact of immigration on supply and demand. The recent surge in population growth added more workers to the labour force, helping to relieve labour shortages. Newcomers also added to demand as they spent money to get settled on arrival and find housing. Members agreed that it was difficult to assess with precision the net effect of population growth on excess demand, but they viewed the first-order effect as roughly neutral.

Governing Council agreed that, on balance, consumption should moderate as higher interest rates continue to work through the economy. But this moderation will take longer than previously anticipated given the stronger-than-expected momentum in consumption in the second quarter and the combination of a still-tight labour market with accumulated savings by households.

Members agreed that the softening of business investment intentions and export growth indicated that tighter monetary policy in Canada and abroad was cooling demand. Firms surveyed by the Bank cited the prospect for slower growth and tighter financial conditions as factors holding back investment. As global growth decelerates, demand for Canadian exports should also wane, although at a slower pace than previously expected given the stronger growth in US consumption.

Governing Council discussed recent data that suggested continued tight labour market conditions with only gradual signs of easing. While demand for workers was still robust, on balance over the last five months, employment had grown modestly below the level consistent with population growth, suggesting some improvement in the balance between labour demand and labour supply. In surveys, businesses said that finding the workers they need had become easier. The unemployment rate ticked up slightly to 5.4% in June—still low by historical standards. The Labour Force Survey indicated that year-over-year wage growth eased in June to 4.1%. This may be the first sign of easing in wage growth, but it was too early to tell. Measures of wage growth have been in a range of 4% to 5% for several months. More data will be needed to judge whether wage pressures are moderating.

Governing Council turned to the dynamics of inflation and discussed recent trends in the data. Headline consumer price index (CPI) inflation eased to 3.4% in May, largely in line with the Bank’s projections. The substantial decline from the high of 8.1% last summer mainly reflected lower energy prices, base-year effects and lower inflation in durable goods prices. Despite the drop in headline inflation, price growth in many goods and services across the CPI basket pointed to persistent underlying price pressures. More than 50% of the components of the CPI basket were still showing price increases above 5%. Firms also indicated that they expected to continue increasing their prices more frequently than normal.

Core measures of inflation had not slowed in recent months, with three-month rates persistently coming in around 3½% to 4% since last September. Also, base-year effects are largely out of year-over-year CPI inflation. As a result, little near-term downward momentum in CPI inflation remains.

While Governing Council members were encouraged by the drop in CPI inflation, the persistence of measures of core inflation suggested the return to the 2% target would take longer than previously forecast. Members agreed that there was considerable uncertainty around the outlook for inflation given the persistence of core inflation and countervailing forces supporting demand.

Considerations for monetary policy

Governing Council members reflected on the evidence that had accumulated since January and its implications for policy. Members agreed that the data clearly indicated that excess demand and elevated core inflation were proving to be more persistent than expected. This led Governing Council to discuss two different scenarios related to the outlook for inflation.

The first scenario is that lags in the transmission of monetary policy from increases in our policy interest rate to impacts on demand and inflation are longer than usual. Given the unusual circumstances of the pandemic and the recovery, and the accompanying large movements in inflation and expected inflation, the increases in the policy interest rate may be taking longer to work their way through the economy than historical experience would suggest.

Members noted that real interest rates had only recently entered clearly restrictive territory in the wake of a higher policy rate and declining inflation expectations. This could explain why the impact of higher interest rates may appear to be delayed, despite having initially cooled demand for housing and interest-rate-sensitive goods. In addition, improving supply chains and a large increase in newcomers to Canada may have boosted consumption at the same time.

In the second scenario, monetary policy needs to be more restrictive to reduce excess demand and bring inflation back to target.

With labour markets remaining tight and household savings still well above pre-pandemic levels, demand may continue to be stronger than previously forecast. In addition, three-month annualized rates of core inflation had been stuck at 3.5% to 4% for eight months, and the downward momentum in headline inflation was waning.

The Bank’s July forecast has inflation close to 3% for another year before gradually returning to target. Members were concerned that inflation remaining above target for this long raises the risk that inflation expectations could settle above what would be consistent with achieving price stability. Contrary to past experience when inflation expectations responded very little to inflation shocks, the current period of persistent inflation may be causing inflation expectations to remain high. As this feeds through to corporate pricing behaviour and wage setting, getting inflation back to the target becomes more difficult.

Members reviewed the survey evidence on firm and consumer inflation expectations. Overall, while short-term expectations are coming down, they remain above the Bank’s inflation forecast. Corporate pricing behaviour also looks to be normalizing gradually, but firms continue to expect larger and more frequent price changes than normal. Similarly, consumers expect high inflation to continue with only a slow return to more normal levels of inflation over time.

Considering these scenarios, Governing Council members discussed how best to balance the risks of under- and over-tightening.

If policy is not restrictive enough to bring inflation to target on a reasonable timetable, there is a risk that rates will have to be increased by even more later. If policy is simply taking longer to work because the lagged effects of nominal tightening are only recently starting to have an impact on overall consumption, over-tightening risks making economic conditions more painful than necessary.

In assessing the risks, Governing Council members took on board some elements of both scenarios. In particular, they agreed that past increases in interest rates would continue to feed through the economy, slowing demand. At the same time, they agreed that both excess demand and underlying inflation were looking more persistent. They also agreed that while long-run inflation expectations still looked reasonably anchored, with inflation projected to be above target for another year, they needed to be alive to the risk that near-term inflation expectations could remain high, making it harder to restore price stability.

The policy decision

At its previous decision in June, Governing Council determined that monetary policy was not sufficiently restrictive and raised the policy interest rate by 25 basis points to 4.75%.

At the July meetings, Governing Council agreed there was a need to raise the policy rate further. Given persistent excess demand and elevated core inflation, and based on the revised outlook, monetary policy needed to be more restrictive to slow growth of demand in the economy to achieve the 2% target.

The discussion turned to whether it was appropriate to raise the rate in July or wait for more evidence to solidify the case for further tightening. The consensus among members was that the cost of delaying action was larger than the benefit of waiting. With inflation projected to be around 3% for the next year and with the upside risks to inflation expectations and household spending, Governing Council members were concerned that the progress toward price stability could stall, and inflation could even rise again if upside surprises materialize.

Governing Council therefore agreed to increase the target for the overnight rate by 25 basis points to 5%.

Members discussed how to characterize the likely future path for interest rates in their communications. They agreed that, given the uncertainties around the forecast and the size and timing of the impact of higher interest rates on demand, they would approach future decisions one at a time based on the available evidence. They agreed they were prepared to raise the policy rate further if inflationary pressures did not ease as projected and progress toward the 2% target stalled. But they did not want to do more than they had to.

Governing Council discussed the key indicators they will evaluate as they continue to assess the dynamics for core inflation and the outlook for CPI inflation. In particular, they agreed to continue to assess whether the following indicators evolve in a direction that is consistent with achieving the inflation target:

• the evolution of excess demand
• inflation expectations
• wage growth
• corporate pricing behaviour

Members also reviewed the Bank’s quantitative tightening program and agreed to continue the current policy of normalizing the balance sheet by allowing maturing bonds to roll off.