By Fergal Smith
TORONTO (Reuters) - Canada's hot inflation and recovering job market are raising pressure on the Bank of Canada to hike interest rates ahead of schedule, with investors looking to a policy announcement this week for clues that the central bank is turning more hawkish.
The BoC, led by Governor Tiff Macklem, is expected on Wednesday to raise its inflation forecast and to largely end stimulus from its pandemic-era bond buying program, starting a countdown of sorts to the first interest rate hike since October 2018.
The central bank has pledged to keep rates at a record low 0.25% until economic slack is absorbed, which would happen in the second half of 2022 in its latest forecast, and has long maintained that the factors pushing up inflation are transitory.
But money markets see a different path, pricing in the first hike by April and nearly 100 basis points of tightening in total next year, up from 35 basis points in September. Investors also see rates rising sooner in other large economies.
The Bank of England could bow to inflation pressures and become the first major central bank to raise rates in November, while there is a growing view that the U.S. Federal Reserve will feel compelled to tighten policy earlier and more aggressively than it would like.
"Worldwide, markets are playing chicken with central bankers, betting that policymakers will follow the Bank of England in capitulating to hotter-than-expected inflation rates," said Karl Schamotta, chief market strategist at Cambridge Global Payment.
Canadian inflation has stayed above the BoC's 1%-to-3% target range for six straight months, climbing in September to an 18-year high of 4.4%, and the economy has regained all the jobs it lost during the pandemic.
If the BoC were to hike before the second half of next year, it would likely adjust its guidance in advance, say analysts, adding that the bank would not want investor expectations to stray too far from its outlook for fear of market turbulence.
The Canadian dollar has climbed in recent days to a four-month high near 1.23 per greenback, or 81.30 U.S. cents, while the gap between Canadian and U.S. 2-year yields has doubled since last month to 41 basis points in favor of the Canadian bond.
"Investors are overwhelmingly convinced that the Bank of Canada will choose to do battle against inflation, assuming that the underlying economy has enough momentum to absorb slack even if monetary conditions turn less accommodative," Schamotta said.
A faster-than-expected pace for rate hikes could surprise Canadian home buyers after they piled into variable-rate mortgages at a record pace this year.
But there is a precedent. In 2010, as the economy recovered from the global financial crisis, then BoC Governor Mark Carney abandoned a conditional pledge to keep rates on hold, and then hiked them earlier than expected.
"If the last time you broke your promise, well then this time it might be reasonable for markets to be pricing in more, rather than fewer, rate hikes next year than the Bank of Canada is currently telling us," said Royce Mendes, senior economist at CIBC Capital Markets.
After uneven growth this year, including a surprise contraction in the second quarter, it is far from certain that the economy will have healed sufficiently to support a faster pace of rate hikes, but that has not stopped investors adding to their bets.
"Central banks are being bullied by the market at the moment," said Adam Button, chief currency analyst at ForexLive. "At some point the Bank of Canada has to acknowledge a shift in market expectations or push back more strongly."
(Reporting by Fergal Smith; Editing by Steve Scherer and Jonathan Oatis)