Why Haven’t Low Unemployment Rates Led to Rising Inflation?
April 10, 2017Five Factors That Are Now Pushing Canadian Bond Yields Lower
April 24, 2017
Canada’s economic momentum has surged of late. Our GDP grew by 2.6% in the fourth quarter of 2016 and by another 0.6% in January.
This uptick in growth has fuelled speculation that the Bank of Canada (BoC) may begin to raise its overnight rate sooner than expected, and if that happens, it will have an impact on both our fixed and variable mortgage rates. (As a reminder, our variable mortgage rates are priced directly on the overnight rate, and our fixed mortgage rates are priced on Government of Canada (GoC) bond yields, which quickly adjust to changes in the BoC’s monetary policy.)
Our improving growth backdrop raised the level of anticipation surrounding the BoC’s meeting last week. Market watchers weren’t expecting the Bank to raise its policy rate yet (it didn’t), but they were keen to see how our improving economic momentum would affect the tone of the BoC’s latest Monetary Policy Report (MPR), which gives us the Bank’s assessment of current economic conditions at home and abroad, and includes projections of our economy’s future trajectory.
The BoC focused its latest MPR around three key issues :
- “The extent to which recent strength is signalling stronger economic momentum in Canada and globally …”
- “How heightened levels of uncertainty, particularly about US tax and trade policies, should be incorporated in our outlook …”
- “How much excess capacity the economy currently has, and the growth rate of potential output going forward.”
Today’s post will take a detailed look at the Bank’s assessment of each of these questions.
- Does the BoC believe that the recent improvement in our economic momentum signals stronger economic growth ahead?
In a word: No.
The Bank attributed our recent uptick in economic growth to “factors that are unlikely to keep adding to economic growth at the same pace.” It credited the recent increase in our GDP growth rate to the recovery in energy-related activity as the oil patch adjusts to the improved oil-price environment, to a rise in spending from households that have benefited from the increased Canada Child Benefit, and to stronger-than-expected housing activity. The BoC then mitigated the potential future impact of each contributing factor:
- It assessed the normalization of energy-related activity as a temporary adjustment to improving oil prices, which appear to have now stabilized.
- It noted that while the increased Child Canada Benefit will continue to support the current level of spending activity, it would no longer fuel any incremental growth in spending (since the increase was a one-time adjustment).
- It predicted that while stronger-than-expected housing activity would continue to provide a boost to our economy over the short term, that boost is “unlikely to be sustainable” and will moderate over the longer term. One assumes that this moderation will occur either naturally or through additional regulatory interventions in our hottest regional markets (which may be imminent).
In addition to attributing our recent growth surge to factors that are unlikely to be sustained over the longer-term horizon, the Bank also lamented that “exports and investment are still weaker than one would expect at this stage of the business cycle”. Improvements in these areas would give our economy a “well-balanced base” and would give the Bank much more assurance “that growth is on a solid footing.” Alas, both continue to lag expectations.
- How should the BoC factor heightened levels of uncertainty, particularly about U.S. tax and trade policies, into its outlook?
Any material changes in the U.S. economic outlook can have a significant impact on Canadian economic growth and the BoC must now struggle to reconcile how President Trump’s campaign rhetoric might translate into actual changes in U.S. tax and trade policies.
While investors were quick to price in the parts of President Trump’s platform that would benefit the U.S. economy, leading to a surge in U.S. equity prices, most of that run-up has since dissipated.
Instead of focusing on tax cuts and stimulus programs, President Trump has spent most of his political capital on immigration bans and a failed attempt to eliminate the Affordable Care Act. In the process, the Republican majorities in both the House and Senate have fought amongst themselves to the point where President Trump has wondered aloud whether it might not be easier to negotiate with the Democrats than with his own party.
Against this backdrop, the BoC is now assuming that any U.S. tax policy changes that would provide a boost to U.S. economic momentum will be delayed. Furthermore, although it notes that it now has a somewhat clearer picture of how the U.S. might alter its trade policies, by introducing measures such as “a border-adjustment tax, targeted tariffs on some products and countries, non-tariff barriers and even broader multilateral trade measures”, the BoC is still uncertain about which specific measures might be enacted, and when.
The wide range of possible U.S. trade-policy outcomes has compelled the BoC to use “an extra degree of caution” when forecasting our export growth. Not surprisingly, that same caution is being reflected in the sentiment of many of our businesses, which the Bank notes are focused on “modest” investment that is “related to maintenance, rather than expansion”.
- How much extra capacity does our economy currently have and how is our maximum potential output likely to grow over the longer term?
These are significant questions for anyone keeping an eye on mortgage rates because the BoC would be expected to start increasing rates on or about the time that our actual economic output comes close to matching our maximum potential output, which is referred to as the closing of the output gap.
The Bank believes that our economy still has “material excess capacity” available and while it notes that overall inflation still hovers near its 2% target, “measures of core inflation are in the lower half of the target band and have been trending downward in recent quarters”. In the meantime, while employment growth has been “firm”, wages and unit labour costs “have risen only slowly”. This lends support to the Bank’s current view that the output gap “could be greater than the midpoint of the range of estimates”.
Accordingly, the BoC now estimates that our output gap will close “sometime in the first half of 2018”, a little sooner than its previous estimate of “the middle of 2018”. That said, given the “significant uncertainty” that continues to weigh on the Bank’s outlook, that prediction reads more like a guess than a forecast to me.
Interestingly, the Bank also observed that “the neutral interest rate in Canada is lower than we thought previously”. The neutral rate is essentially the rate that the BoC assumes would be appropriate when our economy is in balance (not too hot and not too cold). If the Bank is now operating with a lower assumed neutral rate, that means that it considers today’s policy rate to be less stimulative than it had previously thought, and that our economy will require fewer rate increases once our output gap closes.
Five-year GoC bond yields fell eight basis points last week, closing at 1.04% on Friday. Five-year fixed-rate mortgages are available at rates as low as 2.44% for high-ratio buyers, and at rates as low as 2.49% for low-ratio buyers. If you are looking to refinance, you should be able to find five-year fixed rates in the 2.64% to 2.79% range, depending on the terms and conditions that are important to you.
Five-year variable-rate mortgages are available at rates as low as prime minus 0.80% (1.90% today) for high-ratio buyers, and at rates as low as prime minus 0.60% (2.10% today) for low-ratio buyers. If you are looking to refinance, you should be able to find five-year variable rates in the prime minus 0.45% range (2.25% today), depending on the terms and conditions that are important to you.
The Bottom Line: The BoC made it clear that it is maintaining a neutral policy-rate position. While it acknowledged the recent uptick in our economic momentum, it credited this bump to temporary factors that would not sustain this growth going forward. Furthermore, while the Bank estimates that the output gap will close “sometime in the first half of 2018”, it acknowledged that this forecast includes a great deal of uncertainty. It is therefore reasonable to assume that it will be some time yet before the BoC alters its monetary policy enough to significantly impact our fixed and variable mortgage rates.