The Bank of Canada Serves Up Its Latest Economic View With A Dash of Hope Sprinkled On TopJune 1, 2015
What Keeps the Bank of Canada Up at NightJune 15, 2015
- The BoC is concerned about our slowing economic momentum, which was confirmed most recently by our weaker-than-expected first-quarter GDP decline of 0.60%. Despite this, the BoC is reluctant to cut its overnight rate in order to stimulate our economy because it is also concerned about our record-high household debt levels, which it has long called the “biggest risk” to our domestic financial stability.
- If the U.S. Fed raises its short-term policy rate and the BoC leaves its equivalent overnight rate unchanged, the Loonie will weaken against the Greenback. This will give our exporters a competitive boost in U.S. markets, where about 80% of our total exports are sold.
- While Canadian monetary policy is tightly linked to U.S. monetary policy, right now our overnight rate stands at 0.75%, while the Fed funds rate hovers in the 0% to .25% range. That gives the BoC a buffer where the U.S. Fed can raise its policy rate without compelling the BoC to do the same.
For these reasons, a rate hike by the U.S. Fed would hit the sweet spot for the BoC because it would give a boost to our exporters while not impacting the appetite of Canadian consumers for more credit. Of course, none of this matters to the Fed, which will operate on its own timetable when deciding on when to begin tightening U.S. monetary policy. The BoC can only hope that it will do so sooner rather than later.
Which brings us to the question that is on everyone’s mind these days: When will the Fed finally decide to raise its policy rate?
Today’s consensus view is that the Fed will begin to tighten U.S. monetary policy at some point this year. The Fed holds press conferences after its June and September meetings but not after its July and October meetings, and most industry watchers expect the Fed to raise its policy rate at a meeting that includes a press conference. As such, the betting right now is on September … if the Fed does end up moving this year.
Here are the arguments for and against the Fed tightening its monetary policy soon:
Why the Fed Will Raise Rates in 2015
- Last week, David Rosenberg noted that U.S. GDP growth has been positive in six of the last eight quarters, despite a barrage of headwinds that have combined to act against U.S. economic momentum, such as: health-care reforms, the Dodd-Frank regulatory changes in the financial sector, the federal government’s sequester, last year’s tax hikes, and the expiration of some Bush-era tax cuts. Furthermore, he estimated that first-quarter U.S. GDP growth would have been running closer to 3% if adjusted for temporary factors such as the plunging oil price, the surging Greenback, unseasonably cold winter weather and the West-Coast port strike. The Fed has access to this kind of detailed data, and might have a different view of current U.S. economic momentum than the mainstream narrative.
- U.S. employment growth has been on a tear for more than a year, with the U.S. economy adding 200,000 or more jobs in fourteen of the past fifteen months. That run marks the best period of job growth for the U.S. economy in fifteen years.
- Until recently, strong job growth had not fueled rising incomes, but that is now changing, with the average annual year-over-year wage growth for permanent employees rising by 2.9% in May (after rising by 2.4% in April). Also, rising wages are typically a lagging indicator during a recovery and if that’s true in this case, the Fed may already be worried that it has held rates too low for too long.
- The Fed wants to give the markets some warning before it raises rates and many industry watchers thought that it did just that when it removed the word “patient” from its interest-rate policy guidance this past March. Fed Chair Janet Yellen is a well-versed student of Fed history, and when the Fed last removed the word patient from its guidance in January of 2004, it then hiked its funds rate six months later. If the Fed stays true to form, this would also point toward a rate hike in September, six months after the March wording change. While some have rebutted this view by saying that the markets do not appear to be reading this as a signal, others retort that its the Fed’s job to deliver the message and that it’s up to the market to receive it.
Why the Fed Will Not Raise Rates in 2015
- U.S GDP declined by 0.7% in the first quarter of 2015. While this slowdown was attributed to one-off factors, the self-proclaimed “data dependent” Fed may want to see more than one quarter of recovery in the data before it is convinced that the U.S. economy can withstand tighter monetary policy. Also, the yields on longer dated U.S. treasuries have started to rise in anticipation of a hike in the Fed’s short-term policy rate, so there is already a form of monetary-policy tightening underway in the U.S. bond market.
- The second-quarter U.S. economic data are showing signs of improvement, but overall momentum continues to be slowed by the surging U.S. dollar, which has produced many of the same impacts as monetary-policy tightening. If the Fed raises its funds rate, this would be expected to push the Greenback higher still, and would thus strengthen a substantial headwind that is already acting against incremental U.S. economic growth, creating a double whammy of sorts.
- The Fed still wants to see higher inflation for several reasons. For example, as inflation rises, the threat of deflation, which is every central banker’s worst nightmare, subsides. To wit, the U.S. economy just saw 0.2% deflation in April on a year-over-year basis, and that followed a 0.1% drop in March. Higher inflation also erodes the cost of repaying debt, whereas higher interest rates increase the cost of debt repayment. Speaking of headwinds, the U.S. Congressional Budget Office (CBO) recently stated that “the large and increasing amount of federal debt would have serious negative consequences” if interest rates were to rise from current levels.
- The Fed has long seemed more worried about tightening too quickly than about not tightening quickly enough. Perhaps because it believes that it has more tools to deal with higher-than-expected inflation, as opposed to deflation, which renders much of its monetary-policy arsenal ineffective and forces it to experiment with unconventional solutions that are less fully understood, like quantitative easing. Some have argued that the Fed’s lower-for-longer bias was formed in deference to mistakes it made during the Great Depression. History has judged that the Fed tightened monetary policy too quickly in 1937, thus prolonging the Depression, although comparisons between the economic backdrop then and now tend to fall apart upon closer examination.
- The U.S. economy finally appears to be on a more sustainable path to recovery, but the rest of the world’s largest economies still appear vulnerable. Japan has low economic growth rates and staggering debt levels to contend with, the euro zone still suffers from high unemployment, low economic growth rates, and renewed Grexit risks, and China has real estate, debt and stock market bubble risks to manage against a backdrop of its own slowing economic growth. All of these economies have serious structural challenges to overcome, and the Fed may decide to keep rates low as a form of insurance against financial instability risks beyond its borders.
Next week’s Fed meeting will be watched closely for a rate-hike surprise, but more realistically, for insights into what it might do in September .
From a Canadian mortgage perspective, even if the Fed does tighten this year, U.S. Fed Chair Yellen has already indicated that the Fed will adopt a cautious and gradual approach. The Fed’s plans for a drawn-out rate-hike timetable, combined with BoC Governor Poloz’s repeated insistence that our central bank will lag the Fed on the timing of its next overnight-rate hike, should reassure our variable-rate mortgage holders that their borrowing costs aren’t likely to be heading higher for some time yet. On the other hand, anyone in the market for a fixed-mortgage rate should prepare for a bumpier ride, because bond markets typically overreact to shifts in U.S. monetary policy, at least at the outset, and as shifts go, the Fed’s first monetary policy tightening in more than six years would be a significant one.
Five-year Government of Canada bond yields surged higher by seventeen basis points last week, closing at 1.04% on Friday after retracing almost all of the eighteen basis point yield drop we saw during the prior week. Despite this volatility, five-year fixed-rate mortgages are still offered in the 2.49% to 2.59% range, and five-year fixed-rate pre-approvals are available at rates as low as 2.69%.
Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.
The Bottom Line: The BoC would love to see the U.S. Fed raise its policy rate because this would weaken the Loonie in the process, but the Fed still has plenty of reason to be cautious. The U.S. economy has shown encouraging signs of late, most notably with average wages finally increasing, and if that continues we may see the Fed hike its policy rate in September. But a rate hike would push the Greenback higher and might choke off the U.S. economy’s hard-won momentum, and the Fed still seems to prefer to err in favour of a lower-for-longer approach. From a Canadian mortgage perspective, the Fed’s next move should have little immediate impact on our variable-rate mortgages, but it could easily set off a round of increased volatility at the longer end of the yield curve, and that could push our fixed mortgage rates higher. Stay tuned.