OTTAWA—The Bank of Canada raised its policy rate to 1 percent on Sept. 6 citing growth that is broad-based, self-sustaining, and exceeding its expectations. Canada’s central bank had just raised its overnight rate target to 0.75 percent in its last decision on July 12.
“The level of GDP is now higher than the bank had expected,” said the BoC in a press release.
Investors were 50-50 on whether the Bank of Canada would hike rates in September. While the second-quarter GDP increase of 4.5 percent likely sealed the deal, the fact that no quarterly projections or press conference was scheduled for Sept. 6 gave many investors reason to believe policy changes were less likely. Instead, the BoC sent a strong signal that every rate decision is “live.”
In addition, there was no communication from the bank’s senior officers warning markets of the rate hike like there was prior to the July move. The July move was widely expected by markets, but September’s hike was more of a surprise.
The BoC’s growth forecasting isn’t worse than anybody else’s, says Steve Ambler, the David Dodge Chair in Monetary Policy at the C.D. Howe Institute.
“If you look at the major banks, markets themselves, everybody has been surprised on the upside by economic growth,” Ambler said in a phone interview.
“It can’t be anything but good news.”
However, despite recent economic growth that is more than double the bank’s estimate of potential output, inflation continues to languish. July’s inflation reading came in at just 1.2 percent.
“The link between growth and inflation has really weakened quite a lot,” Ambler said.
The BoC targets 2 percent inflation and said the slight recent increase in the headline figure and its core measures “is consistent with the dissipating negative impact of temporary price shocks and the absorption of economic slack.” Thus, it appears the BoC judges the slight pickup in inflation to be more sustainable.
The BoC emphasized in July that the impact of a rate hike typically comes 18 to 24 months down the road. The July projections showed inflation is expected to reach the target by mid-2018. Monetary policy is meant to be forward-looking.
“It could be because growth is more broad-based, that maybe you’ll start to see the link between growth and inflation come back. And if that’s what they [the Bank of Canada] believe they should be more clear in actually telling us that,” Ambler said.
“If the link between growth and inflation really is still missing, then the need to hike rates further isn’t there,” Ambler added.
The Canadian economy tops all advanced economies with its stellar growth. Consumer spending with notable contributions from business investment and net trade is driving it. Importantly, the economy is weaning itself off dependence on the housing market for growth. The rate hike will make borrowing costs rise and aim to dampen elevated household indebtedness.
While global growth improves, financial markets are more cautious given geopolitical risks such as North Korea and ongoing uncertainty stemming from Washington, D.C. The bank attributed the U.S. dollar’s weakness to some of this negativity, which also serves to boost the loonie.
As of the Sept. 5, the Canadian dollar had strengthened to nearly US$0.81 from its July 12 closing level of US$0.784. After the rate hike, it reached its highest level since May 2015 at just shy of US$0.82. The strong dollar may already be weighing on exports, which fell 4.9 percent in July.
“The loonie’s strength is, at this point, not dissuading the central bank from tightening further. We are still calling for a rate hike in December,” according to a note from National Bank.
The BoC also cautioned that the labor market still needs improvement and wage gains are lower than what historical relationships would suggest. Average hourly wages gained only 1.3 percent in July.
With the September rate hike, the two rate cuts from 2015 due to the oil price shock have now been taken back, marking the end of a dark chapter for the Canadian economy, at least from a monetary policy sense.
“Future monetary policy decisions are not predetermined,” said the BoC. It will likely need to see more evidence that inflation is moving toward 2 percent for future rate hikes.
“Close attention will be paid to the sensitivity of the economy to higher interest rates,” the Bank of Canada said. Ambler believes the central bank will be more cautious before raising rates again and is probably done for 2017.
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