The Bank’s interest rate decision and MPR publication did not shed much light on the future of interest rates in Canada. The market was told that the economy is in a good place; it is operating around potential, allowing for a continued tightening of the labour market and inflation is bobbing around target. Governing Council stressed, however, that in order to generate this level of economic activity, stimulative monetary policy is still needed to counteract numerous headwinds. Obviously as these headwinds dissipate, the target interest rate will need to recalibrate higher.
The list of headwinds is long. They include the uncertainty around potential trade protectionist measures, how and when housing activity will stabilize following recent OSFI measures, transportation bottlenecks, and international competitive issues including a new US tax regime and higher minimum wage legislation in some provinces. In his opening statement the Governor said that ultimately rates will need to go up but the pace of the hikes will be “intensely” data dependent. The magic of projected productivity growth and its resulting marked increase in potential growth gives the Bank a narrative to hide behind that allows them to be patient and be “intense” data watchers.
So the abatement of these headwinds will ultimately determine the timing of hikes. For what it is worth, the Bank is expecting growth to pick up smartly in second quarter to 2.5% from 1.3% in the first quarter, as transportation bottlenecks that kept exports from market sort themselves out and as resale activity in the housing market stabilizes. These are probably the key determinants of a July hike so I will let you decide how quickly you believe these rebound. I am not that optimistic.
The other headwinds including trade agreements and competitive issues look like they may be with us for longer. In fact some of the competitive headwinds may actually be structural and be what some politicians believe makes Canada great (or “fair” —unless you are an employer, or consumer, or energy user, or anyone else who benefits from economic activity). Corporate taxes, regulation and (God forbid) a business friendly atmosphere all lie in the realm of our elected officials. Unfortunately, history would suggest that these folks are rarely proactive and usually have to wait for a crisis before acting. I fear these headwinds will continue to blow for some time.
Issues around trade are probably with us for some time as well. Even a quick Nafta resolution would take time for the Bank to assess. In the press conference, the Governor noted that although an agreement may spur an improvement in soft data (confidence) and incite some businesses to move forward with investments, they would wait to see the hard data before acting. Even if an agreement is reached this quarter, that reaffirming data is many months away. This headwind my hold the Bank back for longer than the market believes.
For me, given the negatives weighing on aggregate demand, and the fact that through the Bank’s “judgement” they created more excess supply by manipulating potential, tells me that they WANT to be extremely cautious raising rates. This means that if exports don’t pick up soon and if the housing market continues to languish, a July hike is not certain. I hope I am wrong, but I fear that the profile beyond the next hike is likely to be much flatter than the market expects, taking a long time before we get near 2.5%, the bottom of their neutral rate range.
Having said all this, the big caveat, and the biggest risk for the market is that the Bank’s judgement of what is going on with the supply side of the economy is wrong and ends up setting the stage for the return of persistent above target inflation. Potential growth was significantly shifted higher based on historical revisions to the capital stock and on the forecast that future business investment will overcome everything foreign and domestic politicians and regulators have thrown at the economy and instead respond to faint economic fundamentals.
At the extreme, we are dealing with a Governor that seems willing to risk his mandated inflation target to achieve an undisclosed target for the youth participation rate. This is very different from a central bank willing to accept lower employment participation rates in some segments of the labour market to ensure meeting their inflation mandate.
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