Bank of Canada: Financial Conditions too tight...really?

The Bank of Canada left interest rates unchanged this week and opted to remain dovish by highlighting the material excess capacity in the economy, the competitive issues with our exporters and by reiterating the significant uncertainties that could negatively impact the outlook.  Interestingly, they also made mention of the currency and yield levels again, saying they had remained near the levels seen at the last update.  The Governor expressed his unhappiness with these levels in January and apparently is still frustrated, believing they are at levels inconsistent with getting inflation back to target in a timely manner.

Subsequent to the press release, Canadian GDP for the fourth quarter of 2016 was released and came out above the market’s expectations and the Bank’s outlook, with quarterly growth of 2.6% annualized.  Given the Bank’s focus on the diverging economies between Canada and the US, I cannot resist pointing out that his compared to growth south of the border in the same quarter of 1.9%.  Post the release, analysts seem to be divided whether the number exaggerated the underlying strength.   Detractors focused in on the deceleration in domestic demand, while optimists pointed to business investment, the main culprit of the decline in domestic demand, as masking firmness in the other components of output. 

What cannot be said from the numbers is that the level of interest rates is not sufficiently low enough to drive the household sector to spend.  Growth for this sector was concentrated in interest rate sensitive sectors like housing and cars.  Moreover, these yields that may be considered “too high” are an important factor behind a large swath of the population seeing housing prices soar.  Recently released data show an average single detached home in the GTA is now selling for over $1.2 million, an increase of 28% over the last year, and this is spreading as prices in the 905 region increased 35% over the same period.  

However, with respect to business investment, yields and the dollar are obviously not low enough to offset all the costs imposed by competitive disadvantages in this country including regulatory hurdles, environmental studies and uncertainties around the future economic landscape.  Business investment remains very weak and it is doubtful that slightly lower yields and a lower currency would be enough to finally ignite a dramatic reversal in this sector.  The answer to spur more business investment may ultimately lie more on the regulatory and fiscal side. (Watch US economy for further details and results.)

Out of curiosity, it would be interesting to know from the Bank’s models where yields and the currency would need to be before the Governor stopped giving them an honourable mention, when he would consider them to be in sync with getting inflation back to target in a reasonable timeframe.  It would also be interesting to know the size of any reaction to housing prices from the increased incentives to both domestic and foreign buyers.  Unfortunately, I doubt their models include that reality.