Pump the brakes on rate hikes
IT’S TOO SOON TO BE CERTAIN THAT THE NEW NAFTA WILL ALTER CANADA’S INTEREST-RATE PATH.
Generally speaking, there were two responses on Bay Street to the new North American free-trade agreement: “All that, for that?!” and “Get ready for higher interest rates!”
Financial Post’s Geoff Zochodne did a sweep of the big banks’ economists on Oct. 1 and found that the received wisdom now is that the Bank of Canada will quicken its march to a more normal policy setting.
Bank of Montreal promptly added an extra quarterpoint lift to its outlook for 2019, predicting a benchmark rate of 2.5 per cent within the next 12 months or so, a full percentage point higher than the current setting. Canadian Imperial Bank of Commerce assumes the Bank of Canada will go ahead with an increase later this month and then follow that move with another one in January, earlier than its previous forecast. Derek Burleton of Toronto-Dominion Bank also said a hike on Oct. 24 was “virtually cemented” and that the smart money now is on three additional increases next year, rather than two.
The reason the professional forecasters pivoted so quickly was because logic was on their side. The central bank had identified trade uncertainty as a drag on business investment. With that anchor removed, Canada’s economy should be able to push through other headwinds with more vigour. Faster growth would spark faster inflation, leaving Canada’s central bank with little choice but to raise interest rates to constrain prices.
“We continue to expect the Bank of Canada to resume monetary policy tightening on Oct. 24 in a context where it is hard to justify keeping interest rates below inflation now that uncertainty surrounding U.S.-Canada trade has dissipated,” Matthieu Arseneau of National Bank Financial said on Oct. 5 after Statistics Canada’s latest hiring survey showed the unemployment rate dropped to 5.9 per cent in September, one of the lowest levels on record.
All that makes sense. Still, let’s pump the brakes a little. It’s too soon to predict with so much certainty that the new NAFTA will alter Canada’s interest-rate path. It’s possible Prime Minister Justin Trudeau’s agreement with U.S. President Donald Trump hasn’t changed much of anything.
What was the surprise on Oct. 1? The introduction of a statute that would give Washington influence over Canada’s dealings with China came out of nowhere, that’s for sure. But most assumed the talks themselves would get sorted, including Stephen Poloz, the Bank of Canada governor.
“I don’t remember the last time I read anything about the prospect for NAFTA renewal,” Poloz told me in an interview on July 11, when the central bank released its latest economic outlook. “I thought it was appropriate today to remind people that we should at least be putting a weight on the possibility that it all gets worked out between friends in a way that is beneficial to everybody,” he added. “There’s no reason why it can’t.”
Before this week, the prevailing assumption was that failure to resolve NAFTA by the Sept. 30 deadline set by the Trump administration would have forced Poloz and his deputies to leave the benchmark rate unchanged on Oct. 24, like they did at their last policy meeting in September.
Actually, that would have depended on market reaction and feedback from the central bank’s contacts in the real economy. Policy-makers have stated explicitly that they intend to raise interest rates gradually, and the data since its pause on Sept. 5 have been fairly strong. The Bank of Canada estimates that a “normal” benchmark interest rate — one that neither encourages borrowing nor impedes it — is between 2.5 per cent and 3.5 per cent. That’s still a long way from where the benchmark rate is now, so policy-makers might have been prepared to raise rates even if negotiations had collapsed.
“We continue to judge that higher interest rates will be warranted to achieve our inflation target,” Poloz told an audience in Moncton, N.B., on Sept. 27, a moment when NAFTA’s future was being described as far from certain. “We know that if we move too slowly to raise interest rates, the economy could move firmly above its capacity limits and inflation could establish significant momentum. We certainly want to avoid this outcome.”
The NAFTA talks were noise, not signal; the signal will be in indicators of business investment, and we don’t have those yet. The first good look will come when the Bank of Canada releases its next Business Outlook Survey on Dec. 21. Policy-makers put a lot of weight on that report, but it only reveals intentions. Poloz will want to see evidence of actual spending, too, and that will require patience. Consider: David Bensadoun, the chief executive of ALDO Group Inc., told me in an interview last month that it would take six to nine months for him to simply shift from one supplier in Asia to another. It will be well into 2019 before the central bank decides if it can stop worrying about business investment.
Unlike most of their counterparts on Bay Street, the economists at RBC Capital Markets were unmoved by the week’s big trade story. Non-energy exports have been slow to catch fire despite a couple of years of strong global demand. Uncertainty is part of the problem, but a bigger one probably is that Canada has been muscled out of its traditional export markets by more aggressive competitors, according to RBC.
A new free-trade agreement that looks a lot like the old free-trade agreement won’t fix Canada’s competitiveness issues. One of the reasons the Bank of Canada has promised to raise interest rates gradually is because the country’s exporters need a crutch. That didn’t change overnight on Sept. 30.