A More Sombre Bank of Canada Reflects Worries Over Oil Price Shock

Stephen Poloz, Governor of the Bank of Canada, at a press conference in Ottawa on Oct. 24, 2018. Canada’s central bank held its overnight rate target at 1.75 percent on Dec. 5. (The Canadian Press/Sean Kilpatrick)

OTTAWA—The Bank of Canada is less optimistic about its outlook than it was in October thanks to the sharp fall in oil prices. The BoC, as widely expected, kept its overnight rate target unchanged at 1.75 percent on Dec. 5 and didn’t indicate that it felt the oil patch woes are transitory or could be resolved quickly.

“The appropriate pace of rate increases will depend on a number of factors. These include … the persistence of the oil price shock,” according to the bank’s statement.

In its last interest rate announcement on Oct. 24, the bank said the global economic outlook remains solid and that its approach to raising rates would no longer be “gradual”—interpreted to mean potentially more than one increase per quarter.

The BoC’s hawkish sentiment is more nuanced now given that “activity in Canada’s energy sector will likely be materially weaker than expected.”

The chance of a rate hike in January has fallen from a near certainty in October to about a one-in-three chance, according to TD Securities. However, TD continues to forecast three rate hikes next year, according to Andrew Kelvin, senior Canada rates strategist.

But others like Oxford Economics, have reduced their expectations for 2019 rate hikes from three to two. “There are some concerns out there,” said Tony Stillo, director of Canada Economics at Oxford Economics. “Even some of the interest-sensitive sectors seem to be taking it a little harder than maybe everyone anticipated,” he said, pointing to the weakness in auto sales and the housing market.

Crude Crisis

The entire second paragraph of the longer-than-usual statement, given that it wasn’t accompanied by quarterly forecasts, discussed oil prices.

The U.S. oil benchmark West Texas Intermediate (WTI) is 20 percent lower than at the time of the BoC’s October projections. While Western Canada Select (WCS)—the main type of oil sold by the oil patch—rallied after Alberta’s decision to limit supply, the discount to WTI is still roughly $10 to $15 wider than usual.

Oilsands producer Canadian National Resources announced a $1 billion cut to its 2019 capital spending budget due to the discount on Canadian crude prices.

But a repeat of the devastating effects on the Canadian economy of late 2014 and 2015 isn’t expected. For example, TD Securities said business investment in the oil and gas sector shouldn’t plummet like it did between 2014 and 2017 when it fell from $81 billion to $42 billion.

“Investment in the energy sector has largely flatlined since then, so we don’t see scope for the same sort of negative impact on growth,” according to a note from TD Securities.

If the drop in oil prices is not transitory, the Bay Street banks estimate the hit to GDP would be in the 0.1 to 0.3 percent range.

Heady Growth Gone

Third-quarter GDP slowed to 2.0 percent, but the composition of the growth was disappointing. Business investment fell 7.1 percent as did imports, which boosts net exports and ups GDP dubiously, reflecting slower demand. The BoC’s forecast for fourth-quarter growth was 2.3 percent, but RBC estimates it to be coming in closer to 1 percent.

“Data suggest less momentum going into the fourth quarter,” said the BoC. But a couple of bright spots it expects are business investment outside of the energy sector and exports. The Canadian dollar has fallen by over 1.5 percent since the bank’s October forecasts, which should help export growth.

Sino-U.S. trade tensions were singled out as the biggest risk to the Canadian economy in October, but the bank emphasized that it was a two-sided risk. “Recent encouraging developments at the G-20 meetings are a reminder that there are upside as well as downside risks around trade policy,” said the BoC.

U.S. tariff increases on Chinese imports are on hold for three months as the United States works with China to stop theft of intellectual property, cyber espionage, forced transfers of technologies, and to open its markets.

“We still have the tariffs in place three months from now,” Stillo said about his baseline forecast. He’s adopting a wait-and-see approach, but is not optimistic that China acquiesces to U.S. demands in the near future. A renewal of trade hostilities is another potential red flag on the outlook.

The bigger picture for the BoC is that the overnight rate is still well below neutral—the lower end of its range is estimated to be 2.5 percent—while the economy is operating at close to capacity and core inflation is stable at 2 percent. Thus the bank maintains that rates should be on a path higher, but it appears it more data-dependent than in October.

“There may be additional room for non-inflationary growth,” said the Bank of Canada.

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