A Primer on the Bank of Canada’s Evolving Interest-Rate View

The Bank of Canada (BoC) makes its latest policy rate announcement this Wednesday and while there have been some positive economic signals of late, particularly in the U.S., not everyone is convinced that a corner has been turned.

In anticipation of this week’s meeting let’s take a look at the Bank’s recent comments on where inflation and growth, both in Canada and abroad, are most likely headed in future. I will then overlay these views with the Bank’s Wednesday commentary to look for any changes at the margin next Monday, in an effort to help you gain insight into what all of this might mean for our mortgage rates in future.

The BoC on Canadian Inflation …

• Although recent inflation data have come in higher than expected, “excess supply in the economy and heightened competition in the retail sector will likely keep core inflation well below 2 per cent this year”. The BoC attributed our recent spike in inflation to surging energy prices, which it believes will be transitory in nature.
• The BoC expects overall inflation to return to its target rate early next year, and it has predicted that “core inflation will return to 2 per cent by early 2016”. The Bank continues to place more emphasis on core inflation than on total inflation when gauging the likely timing of future overnight rate increases, so that is now the key inflation measure for mortgage borrowers to monitor.
• The latest Monetary Policy Report (MPR) acknowledges that “some of the key volatile components excluded from the core measure are particularly sensitive to exchange rate movements”. It is interesting to note that already volatile inflation data are made still more so by fluctuations in our currency.  This helps explain why the BoC hasn’t overreacted to surges in overall inflation, as we saw in the most recent Consumer Price Index (CPI) report.

The BoC on the Canadian Economy and Housing …

• The Bank’s most recent forecasts offered the view that the strengthening global economy, combined with the cheaper Loonie, will “lead to a broadening of the composition of growth in Canada” and that our economy “will return to its full production capacity over the next two years.” It will be interesting to see whether our disappointing first quarter Gross Domestic Product (GDP) gain of 1.2%, released last week, alters that forecast.
• Further to that point, the BoC recognizes that “above-potential growth is needed to close the output gap; this is expected to be achieved with a larger contribution to growth from exports and investment”. When you combine our latest GDP result with BoC Governor Poloz’s recent admission that increases in our exports and business investment are “not in the numbers yet”, it appears that the Bank’s prediction of when our economy will return to full capacity is based more on hope than on discernable improvements in the data.
• The Bank expects “a soft landing in the housing market and stabilizing debt-to-income ratios for households”.  While the BoC remains concerned about our household debt levels, it continues to acknowledge that our borrowing rates are slowing and that our “household debt-service  ratio stands at its lowest level on record”. The future path of our mortgage rates is the key factor in the debate about whether our house prices are sustainable. If our mortgage rates rise slowly, our rising incomes should be able to keep pace with our higher borrowing costs, whereas if they rise sharply, our household debt service costs and therefore total debt could become unmanageable. The BoC’s soft-landing prediction is consistent with its stated view that our mortgage rates will rise gradually.

The BoC on the U.S. Economy …

• The Bank has acknowledged the sharp slowdown in U.S. GDP growth in the first quarter of 2014, but it has attributed this to severe weather conditions. The U.S. economy has certainly seen a surge in demand since the weather improved but it is still an open question whether this uptick is just the release of the deferred demand that built up during the cold winter months, or the first signs that the U.S. economic recovery is finally enjoying sustainable momentum. I think we will need to see continued strength in U.S. demand in the coming months to answer this question definitively, but it will be interesting to hear the Bank’s view on the sustainability of this change at the margin. From my point of view, it would be inconsistent to excuse weak performance due to bad weather and then not discount subsequent growth performance when the weather improves and the pent-up demand is released.
• The BoC recently predicted that rising household wealth and improving labour conditions in the U.S. will boost consumer spending and strengthen overall private domestic demand. That said, it believes that the housing recovery will be challenged by tightening mortgage-lending standards and challenging labour market conditions for young workers, which will dampen household formation. I think the momentum we are seeing in U.S. domestic demand will be severely tested as the U.S. Fed continues to taper its quantitative easing (QE) programs. If the taper causes a significant equity-market correction, and many of the experts I read think that it will, U.S. consumer spending could slow sharply. To date, the BoC hasn’t talked too much about the potential impacts of the U.S. taper in its formal commentary and I am curious to see whether this will change.
• The U.S. Federal Open Market Committee (the committee that sets interest rates for the U.S. Federal Reserve) recently said that U.S. monetary policy will remain accommodative “even after inflation and employment are at near mandate-consistent levels”. The Fed is doing everything it can to reassure markets that it will be slow to raise rates once (if) it completely unwinds its QE programs. Former U.S. Fed Chairman Ben Bernanke did the Fed one better in a recent speech at a private dinner, saying that he sees “no rate normalization during [his] lifetime”. (He was referring to the Fed Funds rate, which is currently set at 0%. A normalized rate is considered to be 4%.) The BoC doesn’t like to acknowledge that our monetary policy is very tightly linked to U.S. Fed policy but will the U.S.’s continually evolving ‘lower-for-longer’ interest-rate view make the BoC’s choice of words on Wednesday more dovish at the margin?

My main criticism of the BoC’s recent commentary is that it has given a light touch to the increasing systemic risk that our sharply rising global debt level presents. The Bank has acknowledged the risk of credit bubbles forming in emerging market economies but it hasn’t made the more obvious point that debt levels are basically exploding everywhere. Japan’s debt-expansion rates are leading the way and this week the European Central Bank (ECB) is expected to join the QE party in one form or another.

While many people are under the impression that the world has been deleveraging since the start of the Great Recession in 2008, this is simply not the case. Well-respected U.S economist Lacy Hunt recently pointed out that global debt levels are now 435% of global GDP as compared to 403% at the start of the financial crisis – and global debt is set to accelerate further!

To put that in context, research shows that when an economy reaches a debt-to-GDP ratio of 275%, growth becomes constrained and basically flattens out. That’s why I am still sceptical when analysts project short-term growth surges in the near future. It’s hard for economies to speed up when so many of them are crippled by debt. The BoC should acknowledge this rising systemic risk in Wednesday’s report.

Five-year Government of Canada bond yields fell four basis points last week, closing at 1.53% on Friday. Five-year fixed-rate mortgages are being offered in the 2.84% to 2.99% range and five-year fixed-rate pre-approvals are now offered at rates as low as 2.99%.

Five-year variable-rate mortgages are available in the prime minus 0.65% range, which works out to 2.35% using today’s prime rate of 3.00%.

The Bottom Line: BoC policy announcements have been non-events for some time but I think mortgage borrowers should pay special attention to this Wednesday’s announcement. Views on where the North American and global economies may be headed are diverging and it will be noteworthy to see which side of this growing chasm the BoC stands on. Also, I am curious to see whether the Bank acknowledges the rising systemic risk of global credit expansion now that the ECB is about to enter the QE fray. Stay tuned …