Canadian economy not ready for large interest rate 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 two-per-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 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 Canadasaid.“Bothexportsand 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 withdemandandearnmore 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 alsohurt. at rates in excess of two per cent.

Wages, which had been stagnant, are showing signs of life, a condition 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 there is plenty of demand for Canadian goods and services at home and abroad. They noted slower credit growth could mean 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 farfromwheretheywantto be.

The Bank of Canada reiteratedthattheneutralrate of interest — an imaginary setting at which interest rates are neither helping nor hurting the economy — is around three per cent. In theory,thecentralbankhas to lift its benchmark by 1.75 percentage points to return tonormal.

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.