Poloz Opens The Door For More Rate Hikes

Canada’s economy continues to operate close to full capacity. “Household spending is being dampened by higher interest rates and tighter mortgage lending guidelines.”  The ratio of household debt to disposable income is edging down as household credit growth continues to slow (chart below).

Consumer spending growth has been slowing since mid-2017, led by a pullback in interest-sensitive components such as vehicle purchases, furniture, appliances and dwelling maintenance. With the slowdown in housing purchases, housing-related spending has also slowed.

The sensitivity of consumption and housing to interest rates is estimated to be larger than in past cycles, given the elevated ratio of household debt to disposable income. The impact of higher interest rates likely differs across categories of borrowers, with highly indebted households the most affected.

Meanwhile, exports are buoyed by strong global demand and higher commodity prices. “Business investment is growing in response to solid demand growth and capacity pressures, although trade tensions are weighing on investment in some sectors. Overall, the Bank still expects average growth of close to 2% over 2018-2020.” This is somewhat above the Bank’s estimate of noninflationary growth at full capacity, the so-called ‘potential’ growth rate.

Inflation remains near 2%, consistent with an economy close to capacity. The Bank estimates that underlying wage growth is running at about 2.3%, slower than would be expected at full employment. The actual growth rate in wages has recently been boosted by increases in the minimum wage rate in some provinces.

These economic projections take into account the estimated impact of tariffs on steel and aluminium recently imposed by the U.S., as well as the countermeasures enacted by Canada. “Although there will be difficult adjustments for some industries and their workers, the effect of these measures on Canadian growth and inflation is expected to be modest.”

The Bank wrapped up its press release with the following statement: “Governing Council expects that higher interest rates will be warranted to keep inflation near target and will continue to take a gradual approach, guided by incoming data. In particular, the Bank is monitoring the economy’s adjustment to higher interest rates and the evolution of capacity and wage pressures, as well as the response of companies and consumers to trade actions.”

Bottom Line: This rate hike signals that the Bank of Canada is determined to bring its benchmark overnight rate back to more normal levels and that the economy is strong enough to withstand further rate increases. The Bank believes that stronger-than-expected business investment, higher oil prices and a weaker Canadian dollar offset the adverse effect of greater trade uncertainty. Exports have surprised on the upside because of strong global demand.

The mix of growth in Canada has shifted from housing and consumption to exports and business investment–the desired result of the many tightening moves introduced by the government, the central bank and the regulators to slow the rise in household debt.  The Bank believes that this shift in the composition of growth will result in a more sustainable expansion.

Markets expect the Bank to gradually hike the benchmark rate until it reaches 2% or 2-1/4% by the end of 2019–implying another 2 or 3 rate hikes by the end of next year. Governor Poloz said today at the press conference that the Bank’s assessment of the neutral rate for the benchmark is 2-1/2% to 3%, but it is uncertain how quickly we will get there.

The Governing Council of the Bank is scheduled to meet again on September 5. The next full update of the Bank’s outlook for the economy and inflation, including risks to the projection, will be published in the MPR on October 24, 2018.