WHY INTEREST RATES ARE LIKELY TO RISE AGAIN BEFORE SUMMER
Upbeat forecasts, data suggest BoC will make move soon, says Kevin Carmichael.
The Bank of Canada will quite likely raise borrowing costs again before summer. Where the central bank’s interest-rate path goes from there will depend on how quickly North America’s leaders decide what they are doing with their three-country trade agreement.
Governor Stephen Poloz and his deputies on the governing council opted to leave the benchmark rate at 1.25 per cent for a second consecutive policy meeting on April 18. Poloz refused to get into the “nuts and bolts” of the debate, but you get the impression they at least considered an increase.
“Inflation is on target and the economy is operating close to potential,” Poloz said in his opening remarks at a press conference in Ottawa. “That statement alone underscored the considerable progress seen in the economy over the past 12 months.”
The most obvious sign of that progress is an unemployment rate of 5.8 per cent, the lowest in at least four decades, and the creation of almost 300,000 jobs over the past year. Those people now are making money, shopping, and helping their employers keep up with increased demand. The Bank of Canada did the math and determined that all those new economic actors have increased the economy’s ability to generate goods and services without stoking inflation. Policy-makers now will be guided by an estimate of potential growth of 1.8 per cent compared with 1.4 per cent previously, an impressive increase.
That revision eased whatever pressure existed to change policy this month.
The central bank aims to keep the Consumer Price Index advancing at an annual rate of about two per cent, the midpoint of a comfort zone that stretches from one to three per cent. Policy-makers would have begun their deliberations with a forecast that put inflation at around two per cent for the next couple of years, suggesting higher rates would be needed to keep a lid on prices. However, evidence that Canada’s economic engine can run faster without overheating meant Governing Council could get away with low interest rates for a while longer.
“We have little more room for demand growth within our twoper-cent-inflation target than we believed before,” Poloz said.
Central bankers have decided to use that room to prop up the country’s feeble exporters of non-energy durable goods.
The Bank of Canada’s new quarterly economic outlook notes impressive international
Interest rates remain very low relative to historical experience. This is because the economy is not yet able to remain at full capacity on its own.
sales by service providers, and higher crude prices are increasing returns in the oilpatch. But exports overall continue to underwhelm. The central bank cut its forecast for economic growth in 2018 to two per cent from 2.2 per cent, mostly because exporters continue to lose market share in the United States and elsewhere. At the start of the year, policy-makers predicted exports would add 0.6 percentage point to GDP; it now expects they will offer no support to growth at all.
“Canadian exports will strengthen as foreign demand increases, but not sufficiently to recover the ground lost during recent quarters,” the Bank of Canada said. “Both exports and investment are being held back by ongoing competitiveness challenges and uncertainty about trade policies.”
The status of the North American Free Trade Agreement is the most important source of uncertainty.
Many of Canada’s industries are producing all they can with the staffs and factories they have. Normally, companies in that situation would expand to keep up with demand and earn more profits. Instead, too many executives are refusing to do so out of fear that NAFTA will be overhauled. Transportation bottlenecks and shortages of skilled labour also hurt. All those things limit Canada’s ability to boost exports and could permanently alter the structure of the economy if they persist, Poloz said.
That’s why the path for interest rates over the next couple of years is so uncertain. The headline numbers look great, but they are the product of an extremely low interest-rate setting. Poloz is nervous about what would happen if he took that crutch away.
“Interest rates remain very low relative to historical experience,” the governor told reporters. “This is because the economy is not yet able to remain at full capacity on its own.”
Still, there is enough going right to assume the Bank of Canada will nudge its benchmark higher over the next few months.
Inflation trumps all for policy-makers, and it will be difficult to ignore forecasts that show prices increasing at rates in excess of two per cent.
Wages, which had been stagnant, are showing signs of life, a condition that Poloz said last year would have to be met before he would move interest rates significantly higher. Policy-makers called domestic consumption “robust,” and they boosted their outlook for the U.S. economy, implying that there is plenty of demand for Canadian goods and services at home and abroad. They noted that slower credit growth could mean that Canada’s highly indebted households are adjusting to moderately higher borrowing costs without retreating.
“Some progress has been made on key issues being watched closely by Governing Council, particularly the dynamics of inflation and wage growth,” the Bank of Canada said. “This progress reinforces governing council’s view that higher interest rates will be warranted over time, although some monetary policy accommodation will still be needed to keep inflation on target.”
Policy-makers likely will move soon because they are far from where they want to be.
The Bank of Canada reiterated that the neutral rate of interest — an imaginary setting at which interest rates are neither helping nor hurting the economy — is around three per cent. In theory, the central bank has to lift its current benchmark by 1.75 percentage points in order to return to normal.
Poloz won’t want to do that all at once, but he will be tempted to use moments of relative calm and clarity to start moving in that direction. The central bank’s next interest-rate announcement is May 30, followed by one on July 11. Evidence suggests interest rates will be going up on one of those dates.
It is equally likely that policy-makers will follow it with another long pause. Poloz and his colleagues could change their mind, but at the moment, they are skeptical that the economy is ready for prime time.