Boy can things change in a hurry when it comes to monetary policy expectations. A few weeks ago the market was convinced that the first upward move in rates in Canada would wait until well into 2018. In fact, it wasn’t that long ago that visions of rate cuts still danced in the head of the Governor. Then in mid-month the Senior Deputy Governor acknowledged the stream of positive economic data that has come out over the last few quarters and voila, we suddenly have expectations for a rate hike moved into this year. Some radicals are even saying there is a chance of a move in mid-July, given the Governor’s history of bold moves. But wait, there’s more. Now that the price of oil is suddenly in a bear market and groping for a floor, the take is that this will push any rate hike further back. After all, they wouldn’t dare be raising rates when oil is at the same price that made them cut rates back in 2015. What’s a person with a floating rate mortgage to do?
To figure it out, one has to look at where we have been and where we are going with respect to the output gap. The economy has performed better than the Bank had expected, especially over the last two quarters. Unless you believe that there has been a matching increase in potential growth, this would lead to a narrower output gap than the Bank expected in its last MPR. So the starting point for this upcoming decision is from a higher level of GDP and with a smaller output gap.
In a perfect world, as a policy maker, you would like to have your target rate back to neutral when the output gap is closed. This would suggest the target rate should be in the neighbourhood of 2.5-3% by early 2018. That is not going to happen. We do not live in a perfect world and it is not hard to come up with reasons why rates should remain stimulative to offset numerous headwinds (debt, oil prices, Trump uncertainty, low productivity, blah blah). The question is, as the Senior Deputy Governor asked, “whether all of the considerable monetary stimulus presently in place is still required?”
The fact that we are probably two quarters away from having the output gap closed, even with the economy slowing from its recent pace would suggest to me that the current degree of monetary stimulus is no longer required. The Bank acknowledges that growth is broadening and, importantly that the oil price shock is mostly behind us. This sector that was built on $100 oil has been pared back significantly since 2015 so any impact on the total economy from lower oil prices will be less severe than has been seen in the recent past. The fact that oil is in the low 40s now is different than two years ago. The actions that the Bank took in early 2015 are no longer needed. They can make a very strong case to start the adjustment to higher rates as early as next month.
The adjustment to higher rates started with the Wilkins speech. The question now is when does the Bank ratify that move and give us some idea of the slope of the increases. The July MPR gives the Bank the opportunity to act and explain why less stimulus is needed now. Through its economic projections that will include assumptions around uncertainty, housing, household debt and the currency, they will also give us a sense of the profile of any further rate increases. My hope is that the Bank does not delay and will start to pull back on the current level of stimulus, getting us closer to an appropriate policy setting.
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