Why the Bank of Canada Didn’t Deliver Its Expected Rate Cut

The Bank of Canada (BoC) decided to hold its overnight rate steady when it met last week. Financial markets gave 60% odds that the BoC would drop its policy rate in response to Canada’s weak fourth-quarter data, so this most recent policy-rate decision came as a mild surprise.

The Bank offered a cautiously optimistic view of our economic prospects in its accompanying press-conference commentary and in the forecasts in its latest Monetary Policy Report.

Here are my key takeaways from the BoC’s latest communications:

• The Bank believes that China will overcome its recent turbulence and continue on “a more balanced and sustainable growth path”, while the U.S. economy “remains solid” despite experiencing a disappointing fourth quarter to close out 2015. The Bank lauded the U.S. economy’s “strong employment gains, high consumer confidence and very strong investment outside the energy sector” and predicted that U.S. growth would recover to near 2.5% in 2016.
• Canada’s economic momentum stalled in the fourth quarter as well, largely because of “slower exports to the U.S.” Our economy continues to absorb the shock of lower oil prices, as well as lower commodity prices more generally. As our resource sector shrinks and our dollar depreciates in response, the Bank believes that our non-resource-based sectors will fill the void. But this transition requires “a lot of structural change” and the Bank estimates that it will take “up to three years for the full economic impact to be felt, and even longer for all of the structural adjustments to take place”.
• The BoC acknowledged that the sharper-than-expected drop in oil prices and the consequent negative impacts on our economy have caused “a significant setback compared with [its]October projection”. In response, the Bank pushed out its forecast for when our economy would close its output gap from “around mid-2017” in its October statement to “around the end of 2017” in its latest analysis. (As a reminder, the output gap is the difference between our actual output and our maximum potential output. Interest rates would normally be expected to rise at or about the time when the output gap closes.)
• The Bank emphasized that its latest base-case forecast for our economy did not factor in “the government’s intention to introduce fiscal measures to stimulate the economy”. It noted that these measures could have a significant impact on when our output gap closes, depending on their scale and nature”. It’s hard to blame the BoC for highlighting the importance of a more rigorous fiscal response to our current economic malaise, which seems long overdue in my view.
• The Bank acknowledged that its most recent deliberations “began with a bias toward further monetary easing” and that its decision to hold firm instead was influenced by several factors:
  1. “the likelihood of new fiscal stimulus” being provided by our federal government
  2. the sharper-than-expected decline in the Canadian dollar, which is giving our non-resource sectors “considerably more stimulus than projected” in October and which can take “up to two years” to be fully felt
  3. the risk that an additional rate cut could drive our dollar even lower and thereby trigger a short-term spike in inflationary pressures. The Bank estimated that the plunging Loonie has already added about 1% to our inflation rate. While these effects are expected to be temporary in nature, further depreciation of the Loonie might “influence inflation expectations”. This is a potent phrase in central-banker speak since increased inflation expectations could trigger a spike in our bond yields and damage business confidence to the point where companies decide to forgo investment in productivity enhancements and capacity expansion. The BoC has long said that a pick-up in this type of investment is critical to any sustainable recovery.

At this point, the BoC appears content to keep its last bit of monetary stimulus powder dry and to wait for much-needed reinforcements to arrive in the form of the federal-government fiscal stimulus. While that may have been its main justification for standing pat, I thought the Bank’s acknowledgement that another policy-rate cut might be interpreted by financial markets as a signal of weakness was also noteworthy. This is the first time that the BoC has highlighted the volatility risks that rise as the Loonie continues to fall. Until now, the Bank has appeared to support, at least tacitly, the Loonie’s devaluation, but its decision to highlight the negative risks of the Loonie’s continued fall may be an indication that the Bank believes that the Loonie has now fallen to the point of diminishing returns.

The Bank’s wait-and-see approach seems justified against our current backdrop. It reminds me of the analogy I have used previously about monetary policy being akin to hitting the brakes on an oil tanker and only finding out miles later if you applied the appropriate amount of pressure to hit your target. Only time will tell.

Five-year Government of Canada (GoC) bond yields rose by twenty basis points last week, closing at 0.76% on Friday. Five-year fixed-rate mortgages are available in the 2.59% to 2.74% range and five-year fixed pre-approvals are offered at rates as low as 2.79%.

Five-year variable-rate mortgages are available in the prime minus 0.45% to prime minus 0.30% range, which translates into rates of 2.25% to 2.40% using today’s prime rate of 2.70%.

The Bottom Line: Call centre employees of Canadian mortgage lenders are probably relieved that the BoC didn’t cut its overnight rate as expected. There was widespread speculation that lenders wouldn’t have passed on any of that additional saving to borrowers by lowering their prime rates. If that had transpired, lender phones would have been ringing off the hook today with unhappy variable-rate borrowers. That said, while the BoC didn’t drop its policy rate, it did confirm that it will remain cautious. That stance should help keep both our fixed and variable mortgage rates at or near today’s levels for the foreseeable future.