Since at least July 2017, monetary policy has been shifting. With four hikes since then, through to this July’s increase to 150 bps, the Bank has been removing accommodation in what might be called a search for the neutral rate – that sweet spot where monetary conditions are tight enough to contain inflation and risks in the financial system, but not so tight as to jeopardize what has long seemed a vulnerable recovery.
Now, we believe monetary policy is getting close to the end of this exploratory phase. It is no longer searching for neutral, but approaching it. We believe the gradualism and data dependency that have characterized central bank policy over the past several years are likely to continue.
In the U.S., the economy is remarkably strong and is at full or beyond-full employment – and yet inflation expectations remain well anchored, as wage pressures stay subdued in a tight labour market. The Federal Reserve has been removing accommodation with the goal of slowing the economy down to a more stable trajectory, but at a certain point, in the absence of inflation, you have to wonder how far it needs to go. We expect the Fed will deliver one more hike in December and another some time in Q1 2019, bringing the target rate to 275 bps. And then we expect it will pause.
When you consider that the Fed has more or less dragged Canada onto the path towards neutral, it seems reasonable to assume that if the U.S. pauses on rates, then Canada is likely to get with the program. In short, we are getting closer to the point where the Bank of Canada can take a backseat and watch the data come in. And those data are likely to settle into a slower trajectory.
This only makes sense: at some point, the economy is going to react to a higher rate structure; taking into account the lag effect of monetary policy, that reaction should start showing up in Q4 2018 or Q1 of next year. We would also point out that as the Bank hikes once more this year in October and perhaps again early next year, the yield curve is likely to continue to flatten, which should further encourage a pause in raising rates.
Once the next one or two hikes are out of the way, we expect the Bank of Canada and the Fed to extend the assessment period for incoming data to four or six months. Gradual won’t mean stopping, but neither will it mean systematically hiking rates every quarter.
So rates might be approaching “normal” – but it’s going to take a while to get there.