Why the Bank of Canada Is Stuck in Neutral

When the Bank of Canada (BoC) met last week, it left its overnight rate unchanged, as was universally expected.

While a policy rate change was never in doubt, the key question on the minds of market watchers was how the Bank would interpret the recent surge in our GDP growth, which could come in as high as 3% over the first quarter of this year. If the BoC adopted a more bullish view, it would push the Loonie higher and in so doing, weaken the tailwind that our relatively cheap currency had been providing to our export manufacturers. Also, bond yields would be expected to move higher and this could trigger a rise in our fixed mortgage rates.

In today’s post we’ll look at what the BoC said in its latest policy statement and provide highlights from its latest Monetary Policy Report (MPR), which 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:

The BoC’s International Outlook

• The BoC lowered its global growth forecasts from 3.3% to 3.0% in 2016, and from 3.6% to 3.4% in 2017. The Bank cited “the weaker start to 2016 in some regions” as the main cause for its downgraded forecast. More specifically, in the U.S. it highlighted “weakness in productivity growth” in addition to “weaker consumer spending in January, additional drag from the oil and gas sector on investment and the lagged effect of a stronger U.S. dollar on exports”. It also noted “ongoing deleveraging, weak investor confidence and tight lending conditions” in the euro area, “lacklustre wage growth [that] is restraining consumption” in Japan, and “weaker than expected investment” in emerging market economies.
• The BoC observed that “[global] financial conditions have improved, partly in response to expectations of more accommodative monetary policy in some major economies.” Interestingly, the Bank cautioned that these attempts to stimulate growth would also increase “financial vulnerabilities”, and it highlighted China’s desire to boost credit growth as an example of where short-term gain might lead to longer-term pain. Further to that point, last Friday economist David Rosenberg noted that “China’s corporate debt load relative to GDP has soared from 98% in 2008 to 160% today”, and that’s before factoring in whatever China’s policy makers are planning next.

The BoC’s Domestic Outlook

• The BoC now projects that our GDP will grow by 2.8% in the first quarter of 2016. While this is much higher than its previous forecast, the Bank attributes this upside surprise to “temporary factors” and predicts that this momentum “is likely to reverse in the second quarter”. The Bank cited “volatility in trade flows and uneven timing of household expenditures over the first half of the year”, but also acknowledged that “the positive forces at work in the economy are starting to outweigh those that are negative”.
• Over the longer-term horizon, the Bank raised its GDP growth forecast for 2016 from 1.4% in its January MPR to 1.7% in its latest release. The BoC also lowered its GDP growth forecast for 2017 from 2.4% down to 2.3% and maintained its forecast that GDP growth will slow to 2% in 2018.
• The BoC repeatedly referred to our economy’s ongoing “complex adjustments” in response to the oil-price shock where business investment in the resource sector contracts while our economy gradually rebalances itself toward non-resource sectors. The Bank noted that it expects “deeper cuts to investment in Canada’s energy sector than were forecast in January”. It notes that these adjustments “will have important consequences for the growth of potential output for the next several years”, and more specifically, that “the adjustment of potential output to the decline in commodity prices is expected to continue until 2019”.
• The BoC acknowledged that “the Canadian dollar has firmed” of late, which it attributes to “shifting expectations for monetary policy in Canada and the United States, as well as [to] recent increases in commodity prices”. This strengthening of the Loonie caused the Bank to downgrade its forecasts for non-resource sector export growth, which it now says will be “weaker than previously projected”.
• The BoC said that it would have downgraded its near-term outlook were it not for the fiscal measures that were recently announced in our latest federal budget, which it expects to have “a notable positive impact on GDP”. The Bank believes that this “roughly $25 billion in spending over the next two years” will cause our output gap, which measures the difference between our actual output and our maximum potential output, to close “somewhat earlier” than it had previously projected. The BoC now expects the output gap to close “in the second half of 2017”, although it acknowledges that “the timing is highly uncertain given the complex economic adjustments” mentioned above. As a reminder, the timing of the closing of the output gap is significant for Canadian mortgage borrowers because the Bank would be expected to start raising short-term interest rates on or about the time when this threshold is reached.
• The BoC projects that inflation, as measured by our Consumer Price Index (CPI), will “remain below two percent through 2016 and be close to two percent thereafter”, with core inflation forecast at roughly the same levels. The Bank maintains a long-term two percent target for overall CPI, so this forecast implies that inflation will not force it to alter its expected monetary-policy path in either direction over the projected horizon.

In summary, the BoC downplayed our recent uptick in GDP growth, and while it seems encouraged by the fiscal stimulus measures that were introduced in our last federal budget, it remains cautious about our overall outlook. At its most basic level, this caution is based on concerns about both overall global economic momentum and about our domestic economy’s complex adjustment away from resource-sector-led growth.

In that light, any prospect of a decrease in the BoC’s overnight rate, on which our variable rate mortgages are priced, seems greatly diminished. On the other hand, the BoC continues to use descriptors like “uncertain”, “complex” and “will take time” to suggest that any future increases in our overnight rate are still a long way off, and more covertly, to help damper the market’s reaction to our improving growth prospects (despite BoC Governor Poloz’s protestations to the contrary).

Five-year GoC bond yields rose by four basis points last week, closing at 0.76% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.59% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at around 2.79%.

Five-year variable-rate mortgages are available in the prime minus 0.30% to prime minus 0.40% range, which translates into rates of 2.30% to 2.40% using today’s prime rate of 2.70%.

The Bottom Line: The BoC’s monetary policy remains stuck squarely in a neutral, read-and-react position with our economy not struggling enough to warrant policy-rate decreases but our economic momentum not strong enough to warrant policy-rate increases. Against that backdrop, our fixed and variable mortgage rates are also likely to remain at or near their current levels for the foreseeable future.