Why I Don’t Think The Bank of Canada Will Over-React to the Latest Inflation Data (As the Bond Market Did)
Monday Morning Interest Rate Update for March 26, 2018
Last week Statistics Canada confirmed that year-over-year overall inflation spiked from 1.7% in January to 2.2% in February. At the same time, two of the three gauges that the Bank of Canada (BoC) uses to measure core inflation also breached the Bank’s 2% target threshold last month.
Bond-market investors reacted quickly to the higher-than-expected inflation readings and increased the odds that the BoC would raise its policy rate from 67% to 80% when it meets in May.
There is no arguing that Canada’s inflation measures are running hot at the moment, but I think this was an over-reaction. I continue to believe that the BoC will prove to be much more cautious than bond-market investors, and many mainstream economists currently expect.
When the BoC met earlier this month, in its accompanying policy-rate commentary, it anticipated that inflation would spike over the short term, and it attributed this rise to “temporary factors” that would dissipate over time. The Bank also reiterated its confidence that inflation would “remain close to 2% over the projected horizon”.
While there is no question that the BoC is keeping an eye on rising inflationary pressures, other recent economic data indicate that these pressures may ease on their own in the near future without additional BoC hikes.
For starters, our economy hasn’t been growing as quickly as was hoped.
Earlier this month, we learned that last year’s fourth quarter annualized GDP growth came in at 1.7%, and the initial estimate of last year’s annualized third quarter growth was also revised down from 1.7% to 1.5%. Those results were well below the BoC’s prior estimates of 3% annualized GDP growth for both quarters.
Furthermore, our labour market may not be tightening as quickly as was widely believed.
Our impressive run of stronger-than-expected employment data led market watchers to believe that labour costs were about to spike. There was fear that this would trigger a broad rise in inflation that would leave the BoC no choice but to continue raising its policy rate.
But in a recent speech, BoC Governor Poloz outlined the Bank’s newfound and evolving belief that our economy “is carrying untapped potential that could prolong the expansion without causing inflation pressures”. He outlined the BoC’s belief that our country has another “half a million workers” on the sidelines, and that these untapped labour resources could permanently increase our economy’s non-inflationary output potential by approximately 1.5%.
Most significantly, he said that “we cannot know in advance how far the capacity-building process can go, but we have an obligation to allow it to occur.” I read that as ‘we’re not going to stifle this labour-market evolution by over-tightening monetary policy pre-emptively’.
The Bank also recently introduced a new measure of wage growth, called wage-common, which it believes “is a superior estimate relative to individual sources because of its timeliness, its lower volatility and its good relationships with fundamentals.” This measure indicates that wage pressures had only risen to 2.2% in the fourth quarter of 2017, and is still well below its historical average of 2.7%.
So, we have slowing GDP growth and a central bank that wants to nurture the development of untapped labour-market potential in an environment where there is less wage pressure than is widely believed. Those do not look like conditions that cry out for more rate rises over the near term, at least from my desk.
More broadly, here are several other reasons why I disagree with the bond market’s assessment and why I continue to believe that the BoC will continue to exercise caution at its next meeting in May. (You can also read my more detailed rationale in this post, which I wrote earlier this month.):
- The BoC wants to allow time for the three policy-rate increases that it recently made to work their way into our economy (which BoC Governor Poloz estimated can take anywhere from one to two years to realize their full impact), especially now that our recent GDP growth data have disappointed.
- The BoC wants to allow time to assess the impact of the sixth round of mortgage rule changes that were implemented on January 1, 2018.
- The BoC wants to allow time for our trade picture to become clearer. The future of NAFTA remains uncertain, and while there was some encouraging news on the NAFTA negotiations last week, U.S. President Trump just announced that the Canadian and Mexican steel and aluminum tariff exemptions would expire on May 1, so I don’t think our trade picture has actually improved of late.
- The BoC doesn’t want the Loonie to appreciate further. While each additional Fed rate hike should give the BoC increased flexibility to raise its own policy rate without causing the Loonie to spike against the Greenback, today it hovers at US$ 0.78 even after last week’s Fed rise. That is still considered expensive for our exporters, and a BoC rate hike in May would almost certainly push the Loonie higher and strengthen this headwind further. Importantly, that would also almost certainly undermine the BoC ‘s hope that increased business investment will offset the expected slowdown in consumer spending. Our export sector needs to be humming along for that to happen.
The Bottom Line: I think the shoot-first bond market over-reacted to our latest inflation data when it increased the odds of a BoC policy rate rise in May to 80%. For the reasons outlined above, I believe the Bank will prove much more cautious. If I’m right, our variable mortgage rates won’t be rising in the near future, and any related rise in our fixed mortgage rates should be short lived.