The Latest Bank of Canada Report Implies Our Next Rate Hike May Come in Mid-2017

The Bank of Canada (BoC) released its latest Monetary Policy Report (MPR) last Wednesday and left its policy rate unchanged at 0.50%, as was universally expected.

I always read the MPR with great interest because it gives us the BoC’s views on the state of the world’s economies and includes projections for where the Bank sees foreign and domestic economic growth headed over the next several years.

Here is a summary of the highlights from the latest MPR, with my accompanying comments:

International Highlights

• “Global economic growth remains modest as the world economy is undergoing significant shifts”. Lots of “shifts” to choose from here: the spiking U.S. dollar, China’s slowing growth, lower oil prices, geopolitical instability in the Middle East and Africa.
• The BoC lowered its global-growth forecasts from 2015 through to 2017. It noted that while monetary-policy easing and cheaper oil prices were supporting global growth momentum, the fundamental elements required to make this momentum more sustainable were still wanting. Specifically, the Bank referred to “persistent weakness” in business investment and the “slow progress” of Europe and Japan in implementing much-needed structural reforms.
• “The U.S. economy is in a solid expansion, and the recovery is gradually progressing in other advanced economies”. The BoC now sounds more confident about the sustainability of the U.S. recovery, highlighting its “robust growth in private demand”, while its observation that recoveries in other countries are only “gradually progressing” is a tepid endorsement at best.
• The Bank notes that “growth prospects have softened in a number of emerging-market economies (EMEs)” that the Bank credits with being “the main engine of global growth over the past several years”. This was a candid acknowledgement of the importance of EMEs and it raises a real concern about where we will find new sources of momentum now that this “main engine of global growth” is showing signs of slowing.
• China “continues to undergo a major structural transition” as it shifts its economic focus away from infrastructure investment and exports, and towards the domestic consumer instead. The BoC seems confident that China will implement the structural reforms needed to facilitate this transition, but it still downgraded its Chinese GDP growth forecast to just over 6% for 2016 and 2017. This was an acknowledgement that China’s “significant” housing-market correction would keep construction activity “more subdued” than was anticipated in the BoC’s July projections. That said, 6% GDP growth is still the envy of the developed world and the BoC notes that “China’s demand for raw materials continues to expand”. Although it is seldom remembered or taken into account, after China’s many years of 10%+ growth, China is now expanding a much larger economic base, as the second largest economy in the world. So while China’s growth rate is slowing, its overall level of economic demand still gives the global economy important and much-needed momentum.
• The BoC gave a tip of the hat to India where it predicted that growth “which has averaged close to seven percent over the past two years, should strengthen further”. India is the one country with the population size and sheer scope to create a new economic miracle that would rival China’s recent history. If Indian growth continues to accelerate it could underpin a new commodity super-cycle that would provide a powerful tailwind to commodity-based economies like ours.

Domestic Highlights

• Our economy “continues to adjust to lower prices for oil and other commodities” resulting in “reallocation of labour and capital across sectors and regions”. This transition is being aided by “the stimulative effects of previous monetary policy easing, … solid growth in the U.S. economy, … and the depreciation of the Canadian dollar”.
• We also continue to grapple with the challenge of “rebuild[ing] non-commodity-exporting capacity”, which decreased significantly when the Canadian dollar surged above the Greenback in the aftermath of the Great Recession. BoC Governor Poloz has explained many times now that the export-manufacturing sector has been slow to reap the benefits of our more competitive currency, in part because large swaths of it were killed off during the period of the Loonie’s surge. He has repeatedly said that many of the companies that will take advantage of today’s cheaper Loonie are still in the process of being reinvented. To that end, the BoC noted that “new sources of export growth (such as steel forms and food products) … rose from essentially zero in 2010 to more than $500 million in total in 2014“, and cited these data as early-stage proof positive that “Canadian firms can adapt to changing economic circumstances”.
• The BoC now predicts that our economy will return to full capacity “around mid-2017” which is later than its July estimate of “early 2017”. This is noteworthy for Canadian mortgage borrowers because the BoC would be expected to begin tightening monetary policy (by raising interest rates) as that date approaches. Over the past several years, the BoC has continually pushed out its estimate of when our economy will return to full capacity. Once again, it does so here.
• Overall inflation is expected “to remain in the lower half of the inflation-control range [which is 1% to 3%] until 2017, while core inflation, which strips out more volatile CPI inputs like food and energy, “is expected to remain near 2% throughout the projected horizon”. If overall inflation is not expected to reach the BoC’s target of 2% until 2017, this too implies that the Bank’s next rate hike will occur no earlier than 2017. While it is true that the BoC is predicting that core inflation will remain higher throughout its projected horizon, there was no accompanying language in this MPR to suggest that that prediction concerns the Bank enough to accelerate its policy-tightening timetable.
• Our labour market data “indicate continued slack, and there is little evidence of mounting wage pressures”. That said, our economy added an estimated 160,000 net new jobs over the past year, with 200,000 new full-time jobs being offset by the loss of 40,000 part-time jobs (which is a lot better than the other way around!). Average total hours worked has grown by 1.3 percent, which is “about double the estimated trend pace of growth”. The unemployment rate has understandably risen in the energy-producing provinces, it has stayed relatively flat in the others. On balance, while our labour market recovery has not matched the impressive growth seen stateside, we’re not doing too badly when you consider the outsized impact that the oil shock has had on our more commodity-centric economy.

The latest MPR has a consistent theme about “taking time to adjust”, which leaves me with the impression that the BoC will adopt a cautious wait-and-see approach before moving rates up or down again. It takes time for the full impact of monetary-policy changes to be absorbed into an economy, a reality I once acknowledged when I wrote that setting monetary policy was like hitting the breaks on an oil tanker and having to wait for it to slide along for another five miles before finding out if you got it right. With so much continued uncertainty about the strength of the global recovery and about how the various threats to our economic stability will play out, the BoC seems poised to keep a steady hand on its interest-rate tiller.

Five-year Government of Canada bond yields rose one basis point last week, closing at 0.85% on Friday. Five-year fixed-mortgage rates are available in the 2.49% to 2.59% range, and five-year pre-approval rates can be found at rates as low as 2.64%.

Five-year variable-rate mortgages are still being offered in the prime minus 0.65% to prime minus 0.75% range, but the most deeply discounted versions are now less widely available and may not be around for much longer.

The Bottom Line: The BoC downgraded most of its growth forecasts in the latest MPR, offered a cautious assessment of the global economy, and highlighted several risks that our economy must overcome if it is to continue its fragile recovery. The overall tone of the latest MPR gave me the impression that the BoC wants to leave its stimulative monetary policy in place for some time yet, in order to see how its full impact will be absorbed, and its overall positioning implies that the BoC’s next rate hike may now be delayed until at least the middle of 2017.