OTTAWA—As widely expected, the Bank of Canada raised its key policy rate by 0.25 percent to 0.75 percent on July 12, reflecting its greater confidence in the country’s recent strong economic performance. It’s the first time since September 2010 that Canada’s central bank has raised its overnight rate target.
The move is a culmination of comments made by the central bank’s two most senior officials since mid-June who questioned whether extremely low rates are still warranted. The BoC cut rates twice in 2015 in response to the plunge in oil prices, but the effects of that shock on the Canadian economy are largely a thing of the past.
In fact, Canada led the G7 in economic growth—averaging 3.5 percent—over the three quarters ending with the first quarter of 2017. Business investment, which nosedived during the oil price crash as the big oil companies withdrew operations and laid off workers, was up by the largest amount in almost five years in the first quarter of 2017. The Bank’s Business Outlook Survey showed hiring intentions are at an all-time high as firms expand capacity to meet higher demand.
The central bank forecasts the economy to grow 2.8 percent in 2017 before slowing to 2.0 percent in 2018, and 1.6 percent in 2019. Importantly, this near-term above-potential growth means the economy’s output gap will close around the end of 2017—earlier than the first half of 2018 projected in April‘s Monetary Policy Report (MPR).
“This is good news for Canada … the growth in our confidence that the economy is on a solid trajectory,” Bank of Canada governor Stephen Poloz said at his press conference. “It [rate increase] is a symptom of an improving economy.”
Consumption, fueled by household spending, is the biggest reason for the increase in GDP, but the encouraging sign is that domestic growth is broadening and getting more support from exports and business investment. Consumer spending is supported by the strong job gains—100K in the last two months—increases in wages, and, of course, the rise in debt.
Global growth is also broadening and major central banks including the European Central Bank and U.S. Federal Reserve are likewise moving toward reducing stimulus in their respective economies. The BoC upgraded its forecast for global growth to 3.4 percent in 2017, up slightly from 3.3 precent in April’s MPR.
The Bank’s narrative surrounding the oil price shock is that the Canadian economy is undergoing a complex adjustment—that it is indeed diversified and non-energy exports are key to its transformation. By 2019, exports are projected to grow to account for half of GDP as foreign demand improves.
“As the adjustment to lower oil prices is largely complete, both the goods and services sectors are expanding,” according to the BoC’s press release. The rate hike comes even as the Bank used an oil price assumption that is 10 percent lower than the one used at the time of April’s analysis.
“We said it would take two years for the worst of the adjustment to take place,” Poloz said. Adjustments are ongoing and are most evident in the labour market, which still has pockets of unemployment. People have left high-paying jobs in the oil patch for lower-paying jobs elsewhere.
Canada is slowly getting over the lost national revenue from lower oil prices, but the big thing for Poloz is that the contraction in the energy sector appears to have stopped.
Oil prices have been in a US$40-US$60 price range for over a year. “People have adjusted to that lower price by cutting costs and increasing efficiency,” Poloz said.
Optimistic on Inflation
The biggest questions about the BoC raising rates have to do with below-target inflation. Part of the justification for the rate hike is that the Bank expects inflation to reach its 2 percent target by mid-2018. It emphasizes that monetary policy must anticipate what inflation might do in the future given that its impact typically comes with an 18- to 24-month lag.
In Canada, May’s inflation reading was 1.3 percent—a 6-month low. The Bank’s three measures of core inflation average 1.33 percent.
The Bank believes temporary factors like low gas prices, electricity rebates from the Ontario government, and an unexpected drop in auto price inflation are keeping inflation down.
But the Bank also acknowledges that technological advances and e-commerce—”global structural factors”—could also be at play. The decline in the Bank’s new measures of core inflation could signal that the economy actually has more excess capacity and that potential output is higher than the 1.4 percent average assumption from 2017 to 2019.
Persistent low inflation is a pervasive problem in advanced economies, but it may be being misinterpreted. Technological advances and e-commerce make prices more sensitive to global market conditions and new information. “If lower inflation reflects increased global potential and heightened competition, it suggests higher living standards rather than signalling economic weakness,” according to the July MPR. The Bank says further analysis is needed on this issue.
Came on Fast
Financial markets had priced in a 90 percent chance Canada’s central bank would raise its overnight rate target from 0.50 percent to 0.75 percent on July 12. At the time of the BoC’s last interest rate announcement on May 24, markets anticipated virtually no chance of a July hike.
“Our expectation is the bank will raise rates again in October before hitting pause on their tightening cycle until they have greater confidence that inflation is heading to their 2 percent target on a sustained basis,” said RBC economist Josh Nye in a note.
BMO’s chief economist Doug Porter also thinks a second rate hike is coming in October—and possibly even September—to reverse the rate cuts from 2015. Porter feels comfortable looking for—in total—another three 0.25 percent rate hikes by the end of 2018. “But for once the risks are to the upside of an interest rate call,” he said in a note.
The Bank did not directly tie the rate hike to the end of the oil price shock, and Poloz said monetary policy is data-dependent. The July 12 rate hike is very much evidence of that.
“Today’s increase in interest rates is clearly warranted,” Poloz said.
Furthermore, raising rates now helps avert the unpleasant possibility of needing to raise rates at a faster pace in the future to get higher inflation under control.
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