KPMG Canada says Bank of Canada will need to 'feed the beast' with one rate hike

KPMG Canada says the Bank of Canada will need to raise its key interest rate once by year end to satisfy bond markets demanding credible action on inflation.

The firm has changed its forecast from expecting no hikes to predicting a 25-basis-point increase at the Dec. 9 meeting, which would take the benchmark lending rate to 2.5 per cent, chief economist Ali Jaffery said.

"The bond market is demanding that policy become more credible, whether that is monetary, fiscal or otherwise, in a world where capital is in high demand," he said in a note on Friday.

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Jaffery said bond markets want policymakers to show they are taking the inflation threat from the energy crisis seriously, as well as debt dilemmas in the United States, France and Japan.

"But what really worries me right now is that the bond market is being indiscriminate," he said.

He said Canada's federal fiscal policy is "pretty reasonable" and monetary policy isn't terrible given the state of the economy, but the country is being swept up in a global trend.

The Government of Canada five-year bond yield on Monday was nearing four per cent, almost 100 basis points higher than a year ago, with nearly 40 per cent of that increase coming last month.

Jaffery said another reason for the rise is "the ill-timed hawkish tone from Bank of Canada governor Tiff Macklem at the last press conference," where he indicated inflation from high energy prices was a greater threat than U.S. tariffs.

He traces the start of a 40-basis-point increase to Macklem's "tough talk" at the Sept. 2 rate announcement.

Normally, job and consumer price index reports would guide rates, but oil prices are now in the "driver's seat," so bond investors are demanding more than talk, Jaffery said.

He also said it could be harder for the Bank of Canada to resist rising U.S. rates because a widening spread devalues the Canadian dollar, which could speed up inflation.

Long-term bond yields continue to rise despite weaker-than-expected U.S. economic data, which could stop the U.S. Federal Reserve from hiking rates in October.

Karl Schamotta, chief market strategist at Corpay Inc., said yields are tracking oil prices "far more closely" than inflation.

"That suggests investors believe central bank reaction functions have shifted, with policymakers now responding more to moves in oil benchmarks than to core price measures," he said in a note on Monday.

Schamotta said bond markets base this belief on public appearances by central bank leaders, including Macklem, where they indicated they would no longer "look through" commodity price moves when setting rates.

Jaffery is among several economists who have recently changed their outlook. Others, including those at Bank of Nova Scotia, UBS AG, Manulife Financial Corp. and Oxford Economics Ltd., now predict a hike at the Oct. 28 Bank of Canada meeting.

"We see merit in the Bank of Canada feeding the beast with one performative hike, demonstrating that it will do its part to remove some monetary accommodation and then move back into wait-and-see mode, watching the energy market and letting the data speak," Jaffery said.

"It feels like the most reasonable compromise at this point, given the nascent economic recovery and raised trade tensions."

With files from Financial Post and Yahoo News