Poloz Holds Rates, Sees More Room for Canada's Economy to Grow

(Bloomberg) -- Bank of Canada Governor Stephen Poloz is showing faith in the economy’s ability to prolong its current expansion without fueling inflation, in a decision Wednesday that kept interest rates on hold even as he raised the outlook for growth.

The Ottawa-based central bank offered an upbeat assessment of an economic expansion that’s running close to capacity, and said borrowing costs will eventually rise. But policy makers indicated they are in no rush to thwart the expansion with rate hikes, particularly at a time when plenty of headwinds remain, such as trade uncertainties. The currency dropped and bond yields dipped slightly.

Poloz is trying to fine-tune a return of interest rates to more normal levels, hoping to raise them just enough to prevent inflation from creeping up, and not so quick as to trigger a slowdown. He’s already lifted borrowing costs three times -- in July, September and January -- and said Wednesday the pace of future hikes is now the key question for policy makers.

“The economy is in a good place,” Poloz said at a press conference, citing inflation that has already reached the central bank’s 2 percent target. At the same time, “there is a long list of things that are in the background preventing the economy from getting all the way where it is today all by itself.”

Rate Caution

That list includes high household debt levels that could have a large impact on the economy if rates increase, the uncertain fate of the North American Free Trade agreement and competitiveness challenges, including those from the recently announced U.S. tax cuts that could draw investment away from Canada.

But the central bank struck an optimistic tone. The overall tenor of the message was consistent with Poloz’s narrative that Canada is at the “sweet spot” of the business cycle, where growing demand is actually generating new capacity as companies invest to meet sales, a process he said the central bank has an “obligation” to nurture with stimulative borrowing costs.

Poloz maintained his sanguine view of inflation. Even with price gains expected to rise in coming months, the central bank still expects inflation to return to near the bank’s 2 percent target in 2019, once the temporary impacts dissipate.

“The core message sent today appears to be that Poloz and company remain set on further hikes, but are in no rush to get there,” Brian DePratto, an economist at Toronto-Dominion Bank, said in a note to investors.

Market Reaction

The Canadian dollar slipped after the report and extended declines after the press conference. It was down 0.7 percent to C$1.243 per U.S. dollar at 1:31 p.m. Toronto time. Two-year government bond yields fell to 1.87 percent, from 1.89 percent Tuesday.

Investors predict Poloz will raise borrowing costs twice more this year, which would bring the benchmark rate to 1.75 percent, still below what the bank considers a “neutral level” of between 2.5 percent and 3.5 percent.

Follow our liveblog of market reaction to the Bank of Canada decision

The central bank said monetary policy is “expected to support economic activity over the projection horizon,” which goes through 2020.

A key component of Wednesday’s report was the sharp upward revision to the central bank’s assessment of how much the economy can grow without fueling inflation, a signal policy makers are more at ease with capacity constraints.

Poloz Holds Rates, Sees More Room for Canada's Economy to Grow

It now forecasts potential output to grow by 1.8 percent in 2018 and 2019, before accelerating to 1.9 percent in 2020. In January, the central bank had forecast potential growth for the next two years to average 1.6 percent.

That means that even with the stronger growth outlook, the economy has more room to grow without generating inflationary pressures.

Slower-than-expected growth in the first quarter, meanwhile, leaves the economy with more potential slack than was the case at the end of last year, the Bank of Canada said.

Other Revisions

It now sees first-quarter growth at 1.3 percent, down from a January forecast of 2.5 percent. Forecasts for 2018 were also brought down to 2 percent, from 2.2 percent. But 2019 growth was revised up to 2.1 percent from 1.6 percent.

It’s a vote of confidence in the business community’s ability to take over from the economy’s main driver of growth -- consumer spending -- which is expected to slow over the next two years.

The bank cited transportation bottlenecks for weakness in exports in recent months, and expects this to be reversed. Investment is down in the first quarter, due mainly to the completion of energy projects in 2017. But the positive trend in investment spending is expected to reassert itself in the second quarter. Even housing activity is expected to pick up in the second quarter, after a sharp contraction in the first quarter.

Even the global economy is doing better than forecast in January, the central bank said, making upward revisions to growth and potential output.

All good reasons for why rates are probably heading higher.

©2018 Bloomberg L.P.