The Bank of Canada increased its key monetary policy interest rate by 25bps this morning, to 1.25%.
The decision was accompanied by the latest Monetary Policy Report (MPR), which provided a fresh view of the Bank’s economic outlook. The Bank estimates that growth in 2017 averaged 3.0%, while their outlook for this year has been upgraded slightly, to 2.3%, from 2.1% in October. Growth of 1.6% is projected for 2019, embodying a modest improvement from October’s 1.5% forecast.
The pace of potential growth remained a key concern for the Bank. It is possible that strong demand may be motivating increased inputs of capital and labour, and the Bank will closely monitor developments on this front. In practical terms, although strong business investment has led the Bank to upgrade the level of potential in 2017, the output gap is judged to be in the -0.25% to +0.75% range, suggesting that economic slack has been effectively absorbed. The Bank acknowledged that labour market slack is being absorbed more quickly than previously anticipated. However, wage data and other measures suggest that, in contrast to an overall lack of spare capacity in the economy, some slack may still remain in labour markets.
The diminishing slack has made itself felt in core inflation measures. While temporary factors such as energy price swings will generate near-term noise, inflation is expected to trend close to the midpoint of the Bank’s 1% to 3% band over the forecast horizon.
As always, the MPR assessed the key risks to the economic outlook. Weaker exports are the top risk in light of NAFTA uncertainty and recent imposition of tariffs by the United States. Faster potential output, stronger U.S. growth and more robust consumer spending (paired with rising household debt) were also seen as risks. A “pronounced” drop in home prices in key overheated Canadian markets rounded out the list of concerns.
Key Implications
In light of an impressive run of labour market data and their latest Business Outlook Survey painting a positive picture, the Bank of Canada was widely expected to hike rates today, and Governor Poloz and company did not disappoint. It has become increasingly clear that emergency level interest rates are no longer warranted. But, while rates look likely to continue to rise, the key question remains “at what pace?”
Today’s statement and MPR provided some further indication of the answer. Emergency level rates may not be needed, but that doesn’t mean that the Bank is in a rush to continue hiking. NAFTA uncertainty hangs over the outlook, with the Bank explicitly downgrading the outlook for business investment and trade to account for the impact of negotiations. What’s more, despite the positive run of labour market data, wage growth remains weaker than the Bank had expected. Most explicit was the statement that while the outlook will likely “warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed”.
As such, it remains our base-case view that a gradual pace of tightening is most likely, with the next hike penciled in for July. Data dependency of course means that this is not a lock. Developments in Poloz’s list of areas to watch, including interest rate sensitivity, labour market developments, and inflation dynamics could easily bring the next hike forward, or push it back.
Note that the Bank of Canada Governor and Senior Deputy Governor will speak at a press conference at 11:15AM ET.
