With Economy Almost ‘Home,’ Poloz Is Treading Carefully on Rates

  • Bank of Canada holds rates steady, cites currency, Nafta
  • Even so, activity is close to full capacity, governor says

The Canadian economy is almost home, according to the nation’s central bank, but Stephen Poloz is trying to make sure the roof doesn’t cave in.

In statements Wednesday from Ottawa, the Bank of Canada governor emphasized a cautious approach to removing monetary stimulus, even as he said activity is close to full capacity. At the same time, the Bank of Canada still expects growth to exceed potential through 2018, setting up a trajectory for rate increases that’s less steep than investors had originally priced in after two interest rate hikes in a six-week span earlier this year.

This won’t be “a very aggressive rate hike cycle,” said Mike Greenberg, a portfolio manager at Franklin Templeton Investments in Toronto. “I don’t think they are in a big rush.”

The Canadian dollar sank more than 1 percent against the U.S. dollar and investors pushed back bets on the timing of further interest rate increases from the central bank after Poloz, who left his benchmark rate at 1 percent, warned that the prior appreciation of the currency would dampen export growth and inflation.

“The Bank of Canada is buying itself some time,” said Frances Donald, senior economist at Manulife Asset Management. “It’s easier to target the Canadian dollar than other parts of financial conditions, and it’s clear financial conditions in Canada needed a breather.”

Implied odds of a December rate increase fell to one-in-three after the Bank stood pat, from almost 50 percent before the decision. The yield curve for Canadian Bankers’ Acceptances shows markets are pricing in a less urgent path for rate normalization, with the total amount of tightening expected in 2018 only modestly reduced relative to a month ago.

Erik Hertzberg/Bloomberg

Donald shifted her call for the next rate hike to January from December in light of the cautious tone from the central bank.

Getting “home” is a favorite analogy of Poloz to describe the economy’s very long odyssey back to full capacity in the wake of the financial crisis and oil shock.

Sweet Spot

The economy is in a “sweet spot” where it “could be capable of generating more non-inflationary growth than we are assuming,” Poloz said in a press conference following the rate decision.

The Bank estimates the output gap – the difference between the economy’s potential growth and actual growth – entered the third quarter at zero after torrid growth of 4.5 percent in the second quarter.

Meanwhile, increasingly synchronized global growth paints a relatively sunny picture of foreign demand for Canadian goods and services in the future, although uncertainty surrounding the future of the North American Free Trade Agreement is already hurting growth.

“There’s clearly a dovish tilt running through these releases, but policymakers have given themselves a lot of optionality here,” said Brian DePratto, senior economist at Toronto-Dominion Bank. “Read between the lines –- an economy growing at potential or above with the output gap closed while continuing to create jobs doesn’t need a policy rate at 1 percent.”

Inflation Outlook

Excess capacity in the labor market suggests little risk of inflation overheating in the near term, said Poloz, who highlighted involuntary part-time workers, subdued work force participation among youths, lower than expected hours worked and softness in wage growth as signs the economy has further room for improvement.

The Bank of Canada expects a broad-based pick-up in business investment to continue, with capital spending playing a larger role in driving economic activity. Policy makers raised their assessment of how fast the economy can grow without generating inflationary pressures, with Poloz later telling reporters that the revision was a conservative one.

Inflation is expected to return to 2 percent in the second half of 2018, later than the Bank expected three months ago, due to the loonie’s increase.

"Given our recent history with inflation running below target, we continue to be more preoccupied with the downside risks to inflation," said Poloz.

Rotation of Growth

Household spending and residential investment, bastions of Canada’s expansion in recent years, are poised to contribute less to growth in 2018, with the latter turning into a net drag on activity the following year.

The introduction of tougher mortgage qualifying rules is expected to shave 0.2 percent off the level of gross domestic product by the end of 2019, policy makers said, while rising borrowing costs as well as slower growth of disposal income should bring about a deceleration in consumption growth.

The Bank also revamped its main policy model to reflect that elevated household debt leaves the economy more sensitive to interest rate increases.

Economic growth is expected to moderate to 1.8 percent in the third quarter, which policy makers attributed to temporary factors weighing on shipments abroad, including scheduled curbs on auto production.

The Bank of Canada’s long-desired rebalancing of the economy toward exports and business investment is expected to take shape in the fourth quarter, with growth rebounding to 2.5 percent –- well above the estimated sustainable speed for the expansion.

— With assistance by Greg Quinn, Erik Hertzberg, and Theophilos Argitis

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