Loonie’s strength complicates Bank of Canada interest rate decision

Posted by on September 4, 2017


After the Canadian economy’s sizzling performance in the second quarter, all eyes will be on the Bank of Canada this week for a potential interest-rate hike.

But there’s at least one obstacle standing in the bank’s way: a resurgent loonie.

Since early May, the Canadian dollar has soared more than 10 per cent against the U.S. greenback, propelled by strong economic data that culminated with growth of 4.5 per cent in the second quarter. A rate hike on Wednesday – coming soon after July’s quarter-point increase – risks igniting another rally in the dollar, which finished last week at about 80.7 cents (U.S.).

The loonie’s strength is complicating what would otherwise be an easy decision for the bank, economists say.

“Nudging interest rates a quarter-point higher is clearly warranted after a scorching first half.

“We don’t need rates this low to generate decent growth and can ameliorate future financial-system risks by easing household credit demand,” CIBC’s chief economist, Avery Shenfeld, said in a note.

“But a further climb in the Canada dollar is much less welcome.”

A higher dollar could put a dent in exports. It could also contribute to disinflation at a time when the central bank “needs a bit more inflation,” he said.

How the bank intends to walk this tightrope will become clearer when it releases its policy interest-rate announcement at 10 a.m. on Wednesday.

The benchmark overnight rate currently sits at 0.75 per cent, and whether the bank hikes now or in October, it will likely attempt to keep the loonie’s rise in check by managing the market’s expectations.

If it decides to move this week, it could, for example, conclude its statement by asserting that “monetary-policy settings are now appropriate,” Mr. Shenfeld said. That would send a signal that the bank is probably done tightening for now. The bank could underscore its message by “pointing to still-tame core inflation and a firm Canadian dollar as a drag on growth,” he said.

Alternatively, the bank could leave its interest rate unchanged on Wednesday and delay the hike until its next meeting on Oct. 25. Holding off could send a signal that the bank intends to raise rates only gradually. However, the statement will almost certainly paint a bullish picture of growth, which will make an October hike seem like a slam dunk.

Raising the overnight rate to 1 per cent this week – and signalling that the bank will subsequently move to the sidelines – is probably the best option, Mr. Shenfeld said. “Why not get the message out early that a 1-per-cent rate is here to stay for a while?”

Bank of Nova Scotia also expects the central bank to move sooner rather than later.

“Growth has been far exceeding the Bank of Canada’s forecasts for an extended period,” said Derek Holt, the bank’s head of capital-markets economics, noting that the annualized growth rate over the past four quarters averaged a very strong 3.75 per cent.

If that pace of growth “were to continue unabated, then imbalances and inflationary consequences would put Canada at the outer edge of the global experiment over how fast an economy can grow and for how long without stoking pressure points that would be difficult to reverse,” Mr. Holt said.

To keep a lid on inflation, the central bank will likely hike its policy rate a couple more times in 2018, bringing the total increase to about one percentage point, he said. Still, Mr. Holt said a hike this week is not guaranteed.

Some economists doubt the bank will be in a hurry to pull the trigger.

Benjamin Reitzes, Canadian rates and macro strategist with Bank of Montreal, points out the bank is scheduled to issue only a statement this week, whereas the October meeting will include a more detailed monetary-policy report that will give the bank an opportunity to flesh out its message.

“That’s part of the reason another hike isn’t likely at this juncture,” he said in a note. Bank of Canada Governor Stephen Poloz and senior deputy Governor Carolyn Wilkins “have emphasized that the Bank wants to avoid slamming on the brakes; hiking in consecutive meetings would deliver a message along those lines. And, only having a statement makes it difficult to effectively communicate otherwise,” Mr. Reitzes said.

There are other reasons to expect the bank to stay put on Wednesday, he said. It has been silent since July, “providing absolutely no messaging at all,” he said. “That’s a stark contrast from the lead-up to the July hike when a number of BoC officials were paraded out to deliver the message that a hike was coming.”

The problem with raising rates this week is that it “could sharply strengthen the Canadian dollar and tighten financial conditions more than the bank would like,” he said.

This week will also bring another batch of economic data for the bank to chew on, the highlight being Friday’s employment report for August.

With the economy firing on all cylinders, the report is expected to show another month of solid job growth. Economists, on average, expect a gain of about 15,000 jobs, following July’s increase of 11,000. The unemployment rate is expected to hold steady at 6.3 per cent.

“A hot job market has helped power consumer spending, which in turn has been the big surprise in GDP growth this year,” said Andrew Grantham, senior economist with CIBC.

Courtesy: The Globe And Mail

Posted in: Business Insight

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