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Bank of Canada Upbeat on Economy, Remains Cautious on Rates

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Bank of Canada Upbeat on Economy, Remains Cautious on Rates

The Bank of Canada released an upbeat assessment of the country’s economic expansion, but reiterated the central bank will remain cautious as it seeks to bring interest rates back up to more normal levels.

The outlook was delivered in a speech by Deputy Governor Tim Lane, a day after an interest-rate decision where the central bank left borrowing costs unchanged. The aim of the speech was to outline “the considerations that figured most prominently” in the rate deliberations, Lane said.

Global and Canadian economic data has come in largely as expected, Lane said, bolstering policymakers’ confidence that inflation will remain near the Bank of Canada’s 2 percent target. Still, Lane said the central bank’s policy rate remains appropriately below neutral given “accommodative monetary policy is working to offset several factors weighing on demand.”

“We’ve been balancing the risk of undermining the economic expansion by moving too quickly with the risk of delaying too long and needing to raise rates sharply later to rein in inflation,” Lane said.

Like central banks elsewhere, the Bank of Canada has been trying to figure out how to bring historically low interest rates to more normal levels, without inadvertently triggering another downturn. The central bank estimates that its neutral interest rate — a rate that keeps the economy neither too hot nor too cold — is between 2.5 percent and 3.5 percent, versus its current policy rate of 1.25 percent.

Traders aren’t fully pricing in the next rate increase — which would be the fourth in the cycle — until July, according to Bloomberg calculations on overnight index swaps. The market expects two to three more hikes this year, with the odds favoring two.

The Bank of Canada has already increased borrowing costs three times since July, as the economy runs up against capacity.

Little Slack

Lane said material slack in the economy, “especially” in the labor market, has been largely absorbed and he downplayed concerns about a growth slowdown at the end of last year. Later in the speech, he said the “elevated long-term unemployment rate” and “relatively low youth participation rate” suggests there is still “some slack” in the Canadian labor market.

He tempered the optimism with a list of uncertainties that threaten the outlook. These include everything from a growing protectionist threat in the U.S. to persistent competitiveness challenges for exporters to worries about how highly indebted households will react to higher interest rates.

A cautious approach to interest rates is allowing the bank to assess how the normalization process is moving, including the possibility the expansion is driving investment higher and generating more capacity for the economy to grow without fueling inflation.

U.S. Expansion

Lane was particularly upbeat about the U.S. economic expansion that he said was “solid” and “robust,” with the potential the economy still has upside if it creates a virtuous circle by fueling business and household confidence.

Recent market volatility, which he said may have been amplified by technical factors, also reflects a repricing to a faster expected path for inflation in some economies, Lane said.

Rising bond yields in the U.S. “can be expected” to put pressure on yields elsewhere, including Canada, which could act as a tightening in financial conditions.

More Highlights

  • Canada’s economy is running close to full potential and is “progressing well”
  • Recovery has become more balanced and broad-based
  • On recent market repricing: “In effect, as markets digest what the changing dynamics could mean for central banks, markets themselves are bringing about some of the tightening that would be consistent with an improving world economy”
  • Global outlook remains subject to considerable uncertainty
  • Even with slowdown at end of 2017, underlying details of Canadian GDP suggest the economy is progressing much as central bank thought, with Lane citing strong domestic demand numbers
  • Recent developments on steel and aluminum could have serious consequences
  • The range of possibilities on trade is wide, and trying to quantify impact would not be useful. Working assumption is existing trade arrangements will stay in place
  • Still, uncertainty is affecting business investment and U.S. tax reform may further reduce attractiveness of Canada, Lane said. Policy makers will be looking closely at next Business Outlook Survey
  • By moving gradually, central bank can assess a number of things: whether economy is creating new capacity, inflation dynamics, wage growth and interest rate sensitivity