Almost nobody expected Bank of Canada governor Stephen Poloz to raise the target overnight rate from 125 bps in March, and he didn’t. Yet fixed income markets are still looking towards two and perhaps even three hikes in 2018.
We expect the Bank to raise rates once more this year, at most. That’s not just because of wobbly data and economic risks on the near-term horizon; it’s also because of the way the Bank has begun to see the Canadian economy evolving over the long run.
- First, the data have softened: Q4 2017 GDP growth of 1.7 percent came in below expectations, and Q1 2018 is looking soft. Trade and consumer spending data have weakened and inflation remains subdued.
- Well-recognized risks: The Bank is focused on the impact of higher rates and high household debt burdens on consumers. Another risk is the evolution of the trade landscape, which already seems to be clouding.
- Potential slack in the labour market: In a recent speech, Poloz pointed to groups where there is room for more workforce participation – women, youth, indigenous peoples, people with disabilities and recent immigrants. If higher potential is how the Bank sees the economy evolving, than it’s not running as hot as it would appear; inflation is not a big issue, and the Bank will be negatively inclined to hike.
- Low rates to support job creation, as well as an increase in aggregate supply: The Bank is monitoring new business formation to see how the economy is responding to low rates in developing industries – on which it is pinning its hopes for a resuscitation of trade. The Bank is counting on not just more businesses, but different kinds of businesses – “new firms” that “apply the latest technologies in novel ways,” as Poloz recently described them.
We can make a few observations about this sought-after transformation and monetary policy. First, the evolution needs to happen, because traditional exporters in manufacturing and the extraction industries are not really benefiting from Canada’s weakened currency. Second, any evolution of the economy is likely to be slow, which suggests the Bank needs to be slow as well. And third, the dollar has to remain on the defensive to support the transformation.
Put it all together, and we see a very reasonable case for expecting a slow process for rate normalization. Settle in and get comfortable – even as the global reflation story plays out, we expect the Bank to be cautious.