Bank of Canada on Hold as Trade Uncertainty Weighs on Solid Fundamentals

Rotation into business investments and exports from consumer spending underway while inflation remains at bay
By Rahul Vaidyanath, Epoch Times
September 5, 2018 Updated: September 5, 2018    

OTTAWA—The Bank of Canada kept its key policy rate unchanged at 1.5 percent on Sept. 5, as NAFTA uncertainty remains the primary risk to an economy that is moving in the right direction.

Of note, exports rose by an annualized 12.3 percent, which helped second-quarter economic growth hit 2.9 percent—slightly better than the bank’s 2.8 percent expectation.

No changes in rates were expected for the BoC’s September announcement; however, a 0.25 percent hike is expected for the bank’s next rate decision on Oct. 24.

“The only impediment that’s preventing them from increasing rates is this big downside risk coming from NAFTA trade uncertainty,” said University of Waterloo economics professor Jean-Paul Lam in an interview.

“If that goes away, I think they will raise rates one more time this year.”

Housing Market Dynamics

The BoC appears satisfied with how the economy and consumers are adjusting to higher interest rates and the much-discussed levels of indebtedness coming down. “Credit growth has moderated and the household debt-to-income ratio is beginning to edge down,” according to the BoC.

As mortgages rates have risen in the last year, Janine White, VP of Marketplace & Strategy Development for RateSupermarket.ca said she’s seen an encouraging change in the behaviour of consumers.

“We’re seeing [website] visitors take much more time reading content around mortgages and doing their own research around mortgages which in our view is really really positive,” said White in an interview.

The rotation away from consumer borrowing and spending on housing driving the economy with business investment and exports picking up the slack is the bank’s desired progression for the Canadian economy.

The bank reported that business investment and exports have been “growing solidly for several quarters” despite trade uncertainty, and the housing market is showing signs of stability after the introduction of mortgage stress tests at the start of the year.

It’s been a mostly subdued year for the housing market, but the Canadian Real Estate Association (CREA) reported that July’s 2.1 percent increase in the MLS home price index was the first acceleration in year-over-year home prices since April 2017.

“Consumers are learning about their own personal finances and taking a more proactive approach in understanding what they can afford,” said White, who has noted greater usage of online mortgage calculators.

However, White also noted that more business is going to alternative lenders as people are less able to get a mortgage from the big banks due to the stress tests. Those borrowers end up paying higher rates.

Debunking ‘Gradual’

The bank downplayed July’s 3 percent inflation reading, attributing it largely to the jump in airfares. The bank’s measures of core inflation are firmly around 2 percent—as the economy operates near full potential—and wage growth is moderate. It expects headline inflation to fall back to 2 percent early next year.

“Higher interest rates will be warranted to achieve the inflation target,” according to the bank’s press release. “We will continue to take a gradual approach.” The bank’s policy rate has gone up by 1 percent since July 2017.

But Lam said there are absolutely no signs of imminent inflation pressures and therefore, there’s no rush for the bank to raise rates. If Canada agrees to some form of NAFTA deal, Lam added, the BoC can continue to raise rates at a gradual pace. But he cautions that if no deal is signed, and given the uncertainty with China and the United States, the bank will not raise rates.

“Is it OK for the Bank of Canada to wait and maybe fall behind the curve a little bit? I think they can afford to do that,” said Lam.

Inflation had been doggedly floundering below the 2 percent target for several years. In his speech at the gathering of central bankers in Jackson Hole, Wyoming on Aug. 25, Bank of Canada Governor Poloz said a factor behind this was the output gap actually being higher due to the underestimation of investment behind the growth of the digital economy. So inflation had more room to run.

Poloz explained that this phenomenon supports gradual interest rate hikes as inflation is buffered by upward pressure as the economy gets closer to capacity, but also downward forces as the economy’s potential is actually higher due to underestimating digitalization’s impact.

“Digital disruption is likely to be a major preoccupation of central bankers for the foreseeable future,” he said. This is because of the risk it creates to the inflation outlook, just like any other factor.

The more immediate risk factor to the inflation outlook is the NAFTA negotiations, which began again on Sept. 5. How business investment and exports react to whatever the outcome may be is a major driving factor of future Bank of Canada policy.

Follow Rahul on Twitter @RV_ETBiz