Bank of Canada Raises Rates But Cautions Stimulus Still Needed

The Bank of Canada indicated it’s in no rush to pursue aggressive interest rate hikes, citing “important unknowns” such as the future of Nafta as it raised borrowing costs for the third time since July.

At a rate decision Wednesday, central bank officials led by Governor Stephen Poloz sought to quell expectations Canada’s economic boom could prompt them to move quickly with additional hikes, downplaying any worries about the economy overheating and inflation rising above target.

For months, Poloz has been trying to gradually bring interest rates back to more normal levels amid strong growth and a surge in employment, without triggering an unwanted slowdown. He raised borrowing costs twice -- in July and September -- before adopting a more cautious tone and a pause in the last three months of the year.

“We didn’t walk into this as if it was a no-brainer,” Poloz told reporters in Ottawa. “Given those uncertainties, of course the possibility of not moving at this time was in the air.”

But a recent run of strong economic data was too hard to ignore and Wednesday’s quarter-point increase brought the benchmark overnight rate to 1.25 percent, the highest since the 2009 recession. The move was expected by 26 of 27 economists surveyed by Bloomberg and investors had almost fully priced in a hike.

“We are data dependent and there is no question the data on balance since October have been stronger than our base case,” Poloz said.

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The improved outlook was evident throughout the rate statement and monetary policy report. The central bank painted a picture of an economy with inflation already close to target, output largely at capacity, a robust housing sector, and a faster-than-expected reduction in labor market slack.

Yet even with better economic data in 2017, there seems to be little concern the economy is poised to overheat. In the rate statement, central bank officials repeated their dovish language about moving ahead cautiously and warned they expect the economy will require continued stimulus.

“While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target,” the bank said.

Nafta Uncertainty

As they did in October, policy makers forecast a slowdown in growth to more sustainable levels and predicted output will expand largely with potential going forward. They also talked up key vulnerabilities, most notably the growing risk that Nafta talks, which resume next week in Montreal, will fail. 

“Uncertainty surrounding the future of the North American Free Trade Agreement is clouding the economic outlook,” policy makers said. The Bank of Canada forecast a bigger hit on exports and business investment from that concern even though its base case scenario assumes the agreement will remain intact.

There are also questions around whether the economy has a heightened sensitivity to rate increases. Given the country’s high level of household debt, the concern is they will pack a bigger punch than what has been the case in the past.

Wage gains, meanwhile, still aren’t much higher than inflation, policy makers said, which could indicate slack in the labor market remains even with the jobless rate falling to the lowest in more than four decades.

‘Stalling the Expansion’

Another major concern is quashing the recovery before fully drawing in all of the nation’s idle resources -- such as long-term unemployed and youth workers -- and squeezing out more investment from businesses. The idea is that demand can actually generate supply, at least temporarily, limiting price pressures.

“Raising the policy rate too quickly would risk stalling the expansion, and cause inflation to fall back below target,” Senior Deputy Governor Carolyn Wilkins said in an opening statement at the press conference.

Investors have spent the early days of the year watching central banks around the world for signs the period of extraordinary stimulus is coming to an end. Canada, which is first major economy to see a rate hike in 2018, is ahead of the curve.

Markets are still pricing in another two hikes, which would bring the benchmark rate to 1.75 percent, with the Federal Reserve expected to make as many as three more increases, bringing its rate to 2.125 percent.

Poloz seemed to indicate -- as he has in the past -- that it’s appropriate for Canada to be behind the U.S., which he thinks is at a more advanced stage of its business cycle.

“We’re both in a clear expansion phase, we are behind them in that cyclical sense to some degree,” Poloz said.

— With assistance by Greg Quinn, Erik Hertzberg, Luke Kawa, and Josh Wingrove (