The Bank of Canada increased its key monetary policy interest rate to 1.75%, from 1.50% previously. The policy interest rate is now at its highest level since late 2008, although it remains below the 2.50% to 3.50% range that the Bank of Canada considers its long-term ‘neutral’ level.
The statement accompanying the decision struck a hawkish tone. Despite lingering uncertainties around global trade and market volatility, global financial conditions are seen as accommodative, and the composition of Canadian growth is seen as more balanced. Also notable was the removal of the adjective ‘gradual’ in describing the path forward for policy rates.
Today’s decision came with an update of the Bank’s economic outlook. The latest Monetary Policy Report (MPR) now foresees growth of 2.1% this year (up from 2.0% in their last forecast), with 2019 growth slightly downgraded to 2.1% (from 2.2%), while the 2020 forecast was left unchanged at 1.9%. The downgrade to 2019 reflects a few moving parts – business investment is now expected to be a larger contributor to growth, while consumption was downgraded a bit and inventory destocking also plays a role.
A key development since their last forecast has been the introduction of USMCA. Trade uncertainty had weighed on their outlook, and so the resolution has led to a halving of the impact on their outlook – U.S. trade policy uncertainty (largely China related) still holds back investment and exports, and thus the level of GDP over the projection horizon. Also playing into the Canadian outlook is a modest downgrade of global growth including a notable 0.2 p.p. downgrade of their 2020 U.S. growth forecast, to 1.6%.
At the core of their mandate, the Bank sees the inflation outlook as tame. In the near-term, price growth is expected to remain around its current pace, before moderating to the 2% target by the end of next year as the impact of past energy price changes fade.
Risks rounded out the MPR. Top of the list is a trade conflict between the U.S. and China, which may lead to sectoral shifts and a sapping of foreign demand for Canada’s exports. Next on this list is the risk that USMCA may have a bigger positive impact on confidence than the BoC assumes, leading to stronger growth and inflationary pressures. Also on the list were stronger U.S. growth, a tightening of global financial conditions, stronger Canadian consumption figures and the risk of a pronounced decline in home prices in Vancouver and Toronto.
Key Implications
Bye bye ‘gradual’. A hike was to be expected with near-term growth holding strong, trade uncertainty reduced, and labour markets healthy. All these mean an upward path of interest rates remains the prescription to head off medium-term inflation pressures. The hawkish tone of communication today was more surprising, notably the removal of the ‘gradual’ qualifier, which markets had interpreted as a signal of a once-a-quarter pace of rate hikes. Given the continued emphasis on the incoming data, the removal may be intended to provide more flexibility to respond to upside surprises, especially given their relatively conservative 2018H2 outlook.
The tone emanating from Ottawa may seem surprising in light of slowing spending and consumer credit growth that has received much attention of late, but as the Bank noted today, this slowing is by design. With less rate-sensitive sectors continuing to advance, the ‘fuel’ of low borrowing costs is increasingly un-needed. A shifting of growth sources (and moderation of the pace of overall growth) is then the natural result. Importantly, healthy investment intentions, as captured in the Business Outlook Survey even before USMCA was achieved, suggests that the rotation of growth is set to continue, with other sectors picking up the slack as households adjust their budgets to the new environment.
This is not to dismiss the risks. The Bank’s communication today re-affirms our view that three additional rate hikes are likely next year, with the first coming in January. But, as discussed in our recent Dollars and Sense, the linchpin of this forecast is consumer behaviour. It is crucial that the moderation of consumer spending remain just that – a moderation, rather than a pause or outright contraction. Should rising rates begin to have an outsized (and growth-sapping) impact on spending/credit growth, we’d expect at least a pause (beyond the spring 2019 break we’ve already penciled in) to re-evaluate the path. So while we think the Bank of Canada will hit ‘neutral’ by late next year, even with the change in tone today the risks to this call are skewed towards hitting the 2.50% mark later, rather than sooner.
Note: The Governor and Senior Deputy Governor of the Bank of Canada will speak at an 11:15AM ET press conference.Â
