The Bank of Canada Hikes Rates

At its first scheduled policy announcement of 2018, the Bank of Canada (BoC) increased its overnight target lending rate 25 bps to 1.25 percent. With this increase, the BoC has lifted the overnight rate above where it was in 2015 when oil price declines caused it to cut rates twice that year. In this special report we break down the statement from the Bank of Canada and consider the likely monetary policy path for the year ahead. In short, the inflation backdrop should be adequate to justify further rate hikes, but an over-leveraged consumer and lingering worries about NAFTA will be among the key hurdles between the BOC and an untrammeled path to higher short-term interest rates in Canada.

Strong Overall Economic Backdrop

Canadian GDP grew at the fastest quarter-over-quarter pace of any G7 economy in the first two quarters of 2017, reflecting less of a drag from energy-related spending as oil prices rebounded, but has since slowed (Figure 1). Real GDP expanded in Q3 at just a 1.7 percent annualized pace, down from a breakneck 4.3 percent in Q2. Flat month-over-month GDP growth in October disappointed expectations and gave pause to market participants anticipating a short-term rate hike

However, other data have indicated underlying economic strength. Retail sales are on pace to end 2017 at one of the fastest growth rates in recent memory. Consumer price index (CPI) inflation came in at 2.1 percent in November, just above the midpoint of the BoC’s 1-3 percent target rage (Figure 2). Most encouragingly, Canada’s unemployment rate sank 0.2 percentage points to 5.7 percent, the lowest in 40 years (Figure 3). The BoC highlighted close to target inflation and stronger-than-expected consumption and residential investment, “reflecting strong employment growth,” in its policy statement announcing today’s rate hike.

Expectations for a rate hike at the January meeting jumped on the day of the employment report and financial markets began to price in a higher rate environment. Those expectations were warranted as evidenced by today’s rate hike, but there are a few hurdles that stand in the way for the BoC this year. We highlight these risks and will be following up on these themes throughout the year.

The Balancing Act Facing Poloz BoC Governor Stephen Poloz now has to weigh staying his hand, potentially stoking higher inflation as the labor market overheats but lending support to GDP growth, or using further rate hikes to cool down the economy. Adding to hawks’ concerns are recent minimum wage hikes, such as Ontario’s increase to $14 an hour as of January 1, up from $11.60 previously – a 21 percent jump. Some Ontario Tim Hortons locations have already raised prices on their breakfast menu this year, which may signal broader price changes to come. Admittedly, core measures of inflation are a bit lower than the headline at present, but all are moving in a decidedly upward trajectory (Figure 4). For the BoC, as with other central banks around the world, low unemployment has not led to meaningfully higher inflation as it has in prior cycles, although we could be at an inflection point on that front.

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