The Bank of Canada Holds Rates Steady and Dampens Rate-Hike Expectations

The Bank of Canada (BoC) left its policy rate unchanged last week, as expected. The Bank also sounded more cautious about hiking rates in the near future, and that was somewhat unexpected (at least to market watchers who are not regular readers of this blog).

Uncertainty was the BoC’s key theme, around everything from inflation to wage growth to trade policy. To its credit the Bank was willing to admit that we have entered a period of heightened uncertainty, where its plans may change quickly in response to new data (unlike in the U.S., where the Federal Reserve sounds determined to raise rates regardless of whether the current U.S. economic data support additional increases).

The BoC’s announcement also included the release of its quarterly Monetary Policy Report (MPR), for October. The MPR provides us with the Bank’s latest assessment of the current economic conditions at home and abroad and includes forecasts of key economic data.

In today’s post I’ll provide the highlights from the latest MPR broken down between its international and domestic commentary, with my related comments under each bullet. Then I’ll close with a summary of the four main causes of uncertainty the Bank is now grappling with.

International Highlights from the BoC’s October MPR

• The BoC observed that “global economic expansion continues to strengthen and broaden across countries” and it projects that global growth will average 3.5% from 2017 to 2019. That said, the Bank highlighted “substantial uncertainty” around this forecast, specifically “around U.S. trade policy as well as geopolitical developments”.

In other words this forecast is written in pencil, not in pen.

• The BoC continues to believe that U.S. business investment will expand “at a solid pace” and that consumer spending will “stay firm, supported by strong labour market conditions”. It also expects that U.S. exports “will likely continue to be a drag on [U.S.] growth”.

U.S. consumer spending has been underpinned by increased household borrowing, and most notably, by record levels of auto-loan and student-debt accumulation. The delinquency rates on both loan types have risen consistently this year and that causes me to question the BoC’s optimism around U.S. consumer spending.

I also disagree with the Bank’s assessment that the U.S. labour market is “strong”. U.S. wage growth has barely kept pace with U.S. inflation, even though official U.S. unemployment is quite low at 4.4%.

Lastly U.S. businesses are grappling with heightened trade-policy uncertainty in the same way that Canadian businesses are, and I think that could cause them to delay their investment plans, as may the recent Fed rate increases, which I believe will prove ill-timed.

• The BoC observed that Chinese economic activity “has been somewhat stronger than anticipated” but expected that it will “soften in the coming quarters”. The Bank noted that “financial stability risks remain elevated as total credit continues to expand at a strong pace” and it predicted that Chinese GDP growth would slow from 6.8% to 6.3% in 2019.

Slowing Chinese growth matters to our economy because China is the marginal buyer of most of the world’s commodities. So while we don’t have much direct trade with China, its demand significantly impacts world commodity prices, and our economy relies heavily on commodity exports. Bluntly put, if China’s economic momentum slows, our momentum is likely to slow alongside it.

Domestic Highlights from the BoC’s October MPR

• The BoC observed that Canadian GDP growth “grew rapidly” in the second quarter and was “broadly based”. It noted that “consumption and residential investment was robust”, and also that “exports and business investment picked up”. The Bank now expects that GDP growth will slow from 4.5% in the second quarter to about 2% for the remainder of the year, but will still maintain “above-potential pace”. It is forecasting that consumption and residential investment will decline, due to both the recent rate increases and the latest round of mortgage rule changes, but that business investment will “remain steady” while “the contribution from exports is expected to improve”.

I can much more readily see consumption and residential investment declining than I can see business investment holding steady and exports improving. Consumer spending accounts for 58% of our total GDP and if it drops, I think businesses will become more cautious. Also, while the Loonie has sold off recently, it remains at elevated levels, and that combined with the unravelling NAFTA negotiations does not bode well for our exports.

• The Bank now estimates that our economy is operating at “close to capacity” and forecasts that our output gap is now “between 0.5% and -0.5%”. (As a reminder, the output gap measures the gap between our economy’s actual output and its maximum potential output.)

This is significant because inflation should start to accelerate when our output gap closes. The fact that it hasn’t yet done so has caused the BoC to conclude that our economy’s potential output is expanding more rapidly than its actual output. The Bank now expects that it will take until mid-2018 for the output gap to close. (Governor Poloz coined our current period of extended non-inflationary growth as “the sweet spot” in the economic cycle.)

Even that forecast shouldn’t be taken as a guarantee however. The BoC has been predicting that the output gap will close in the not-too-distant future for some time now, so I’ll believe it when I see it.

• The BoC now forecasts that inflation will reach its 2% target “over the next several quarters”, by about “the second half of 2018”, and the Bank expects that it will stabilize after that. If it looks like inflation might overshoot at around that point, the Bank may raise rates again, but it also reconfirmed its belief that households “will be more responsive to interest rates when they are carrying elevated debt loads”.

That’s another way of saying that with today’s high debt loads the BoC won’t need to raise rates by as much as has been required in past cycles to slow the economy and bring inflation back into line. And it should also reassure those who continue to fear that the BoC will raise rates precipitously.

• The BoC acknowledged that while the unemployment rate has continued to fall, “there is evidence of slack remaining in the labour market”. It noted that our average hours worked are still “below trend”, that our youth participation rates “remain low”, that “various measures of wage growth also remain below their historical averages”, and that labour-cost pressures overall “are below what would be expected at this stage of the cycle”. On balance, the Bank estimates that “labour markets are not yet a source of inflationary pressures and the opportunities for further expansion of employment remain”.

In spite of these specific observations, the Bank sounded upbeat about our labour market’s overall momentum, which sounded somewhat contradictory to me.

As mentioned above, uncertainty was the BoC’s watchword in its latest MPR, and to that end, here are the four key forecasting risks that the Bank is focusing on in the current environment:

1. Not correctly capturing the causes of continued low inflation – The Bank acknowledged that inflationary pressures have remained softer than expected for some time. It conducted a detailed study of globalization, technological advances, and the impact of imported disinflation from other countries and concluded that these have had only a minor impact on Canadian inflation. While the Bank believes that more traditional explanations like sector-specific factors, overestimates of growth, and/or underestimates of our economy’s excess capacity account for the discrepancy, it recognizes the risk that other, yet-to-be-captured factors may also be at play.
2. Underestimating/overestimating our economy’s capacity for generating non-inflationary growth – The BoC has said that it must “anticipate the road ahead” when setting monetary policy, and forecasting when our output gap will close is a key part of that anticipation. But as our actual economic output grows, so too does our maximum potential output. That makes it difficult to pinpoint when the gap between them will actually close (because both are moving targets). The BoC risks both overshooting and/or undershooting on its monetary policy timing if it doesn’t gauge the output gap correctly.
3. Not correctly capturing the causes of the continued softness in wage growth – The BoC can’t fully explain exactly why our average wage growth hasn’t recovered when our unemployment rate has now returned to pre-crisis levels. While there is typically a lag between wage growth and job growth, the current lag has been longer than expected. The Bank worries that other factors, like globalization “may be affecting wage dynamics” more than it has accounted for thus far.
4. Underestimating the impact that rate hikes will have on our elevated household debt levels – The BoC recognizes that today’s elevated household debt levels make our economy more sensitive to rate hikes, but it’s not sure by how much. There is a risk that the Bank’s two most recent rate hikes combined with the latest round of mortgage rule changes may have more of an impact on our economy than our policy makers have previously estimated.

The Bottom Line: The BoC believes that we are now in a period of heightened uncertainty as a result of the numerous factors outline above. Against that backdrop, additional rate increases are highly unlikely over the near term and that means that both our fixed and variable mortgage rates should remain at or near their current levels until our economic picture becomes clearer, and until the Bank is much more confident about the appropriate path forward.