The Bank of Canada (BoC) will announce its monetary policy decision on Wednesday at 1400 GMT, and expectations are for policymakers to refrain from raising rates for the second meeting in a row. While inflation edged up recently, the economy slowed and trade risks have remained elevated, presenting a dilemma for the Bank. On balance, officials may retain a cautious bias for now, while they monitor both economic data and trade developments.
The BoC appeared quite cautious when it last met, indicating that trade developments are “an important and growing source of uncertainty” – referring of course to the tariffs announced by the US and the ongoing NAFTA negotiations. On the economy, officials noted that Q4 GDP was disappointing. The lack of hawkish signals triggered a negative reaction in the Canadian dollar, as investors pared back their rate-hike expectations.
Ever since, developments have been mixed. On the one hand, the economy appears to have slowed further in Q1, as GDP growth turned negative in January. And while there have been some encouraging headlines suggesting progress in the NAFTA talks recently, there hasn’t been any concrete agreement the Bank can rely on. Trade risks are still present, and the BoC is unlikely to dismiss them because “the likelihood” for a deal may have risen. Not to mention that non-NAFTA trade uncertainties have increased notably over the past month as well.
On the other hand, inflation is on the rise. The CPI rate surprisingly surged to 2.2% in February, a touch above the mid-point of the BoC’s 1-3% target band, while the core rate that excludes the effects of volatile items reached 1.5%, its highest level in a year. While the Bank expected inflation to head north in its latest set of forecasts, as the effects of past declines in energy prices faded, the magnitude and speed of the increase may have caught policymakers off guard. That said, there’s a possibility the Bank “looks through” this surge as being owed to temporary factors, such as recent minimum wage hikes and a surge in internet service pricing.
Bearing the above in mind, policymakers have a challenging task at hand. Disappointing economic growth and elevated trade risks argue for rates to stay unchanged for a while, while mounting inflationary pressures argue for rate hikes to come sooner rather than later, and the Bank must strike a balance between the two.
On the margin, the BoC appears to have more incentives to remain cautious for now, as opposed to striking an optimistic tone. It may continue to signal that any future rate hikes will be gradual, taking its time to monitor whether the economy’s recent slowdown is transitory and how the NAFTA negotiations play out. In the meantime, if inflation continues to soar higher, the Bank could always reassess its outlook and raise rates in a more aggressive pace in the future.
Looking at market pricing, while investors see only a 10% probability for a rate hike at this meeting, that number jumps to 44% for an increase at the May meeting, while a hike in July is virtually fully priced in according to overnight index swaps. Should the Bank retain a cautious bias, markets could begin to doubt whether a July hike will indeed materialize, pushing the loonie lower. In this case, dollar/loonie could edge higher and challenge the 1.2625 zone, which acted as a reliable barrier to price advances in recent days. An upside break of that area may open the way for a test of the 1.2740 hurdle – notice that the 100-period moving average on the 4-hour chart lies not far above, at 1.2750.
Conversely, if the Bank appears more worried about the pickup in inflation, hinting that more rate hikes are looming, then the loonie could extend its recent gains. Dollar/loonie could edge lower, with immediate support likely to come around 1.2540, a level that has managed to resist a downside violation on numerous occasions lately. Sharper declines would shift the focus to 1.2450, defined by the low of February 16.
Last but not least, besides the rate decision, the Bank will also release updated economic forecasts for the Canadian economy, and Governor Poloz will hold a press conference after the meeting at 1515 GMT. Both of these could also impact price action in dollar/loonie.
