Slow and steady

While the Bank of Canada’s path to normalization is well defined, it will likely remain gradual.

As widely expected by market participants, the Bank of Canada held rates steady at 1.5 percent at the September meeting. Attention has now shifted to the next announcement in October and beyond. We think the Bank should – and will – continue on a very gradual path towards policy normalization for a few reasons.

Inflation is (still) subdued: July’s headline inflation number surprised to the upside, probably boosted by transitory price increases for travel and gasoline. However, importantly, the core measures, an indication of the underlying inflation trends, were unchanged or up only marginally, averaging out at two percent*.

Household debt is (still) high: Higher rates have begun to slow credit expansion. The household debt ratio now stands at 170.2*, indicating consumers owe $1.70 for every dollar of disposable income. That is extremely burdensome, and it’s creating a delicate balancing act for the Bank. While some consumption growth braking is expected and even desired, over-patrolling rate increases could cause demand to slow too much, too fast, sending consumption into free fall.

Trade growth might be capped: Notwithstanding unresolved NAFTA renegotiations, recent trade data have been strong, thanks largely to rising oil prices. However, if such is the trend for trade growth, we would need to see higher oil prices and/or higher export volumes. On that front, a cautious view is warranted for two reasons: the inability to ramp up pipeline capacity and nascent signs of slowing global trade – the S&P GSCI Commodity Index, a broad measure of commodity prices, is currently down more than 7% from its May peak*.

No employment pressure: The unemployment rate has fallen to 5.8 percent but there is little to suggest labour force pressures are building. Job creation has averaged just 3k jobs per month thus far in 2018, a marked slowdown from 20k jobs per month over the past twelve months*. With part-time jobs growing at the expense of full-time positions, there is also no real indication of growing wage pressure – a key downside risk to the Bank’s inflation outlook.

Market signals are flashing yellow: The yield curve – in both the U.S. and Canada – is flattening. History suggests that when the difference between short- and long-term rates is near zero or negative, a reversal of the economic cycle is around the corner. We’re not there yet; and we don’t believe a recession is imminent. Yet the curve is signalling that the risk of monetary policy error is on the rise.

Put it all together, and we believe that while the Bank of Canada’s path to normalization is well defined, it will remain gradual.

*Source: Bloomberg, as of 8/31/2018


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