Bank of Canada Raises Rates, Keeps Hiking Path Amid Trade Rows

(Bloomberg) -- Bank of Canada Governor Stephen Poloz brushed aside concerns about trade wars and pressed ahead with a fresh interest rate increase as inflation hovers at its highest in seven years.

The Ottawa-based central bank raised its overnight benchmark rate by a quarter point to 1.5 percent on Wednesday, the second hike this year and fourth over the past 12 months. The statement didn’t introduce any new “dovish” language, with officials only reiterating that rates will need to rise further, albeit gradually, to keep price pressures in check.

The move signals policy makers are determined to bring rates back to normal levels, and are confident in the Canadian economy’s ability to cope with both higher borrowing costs and the mounting trade tensions. It also suggests the benefits to Canada of strong U.S. growth -- by fueling exports and business investment -- are outweighing the costs and uncertainty imposed by Donald Trump’s trade policies.

“The Bank of Canada decided today that the things we know look bright, and this outweighs the concern we have over the potentially bad outcomes of the things we do not. In other words, the known knowns outweigh the known unknowns,” said Jeremy Kronick, associate director of research at C.D. Howe Institute.

Wednesday’s move was fully priced in by markets. Investors have also been anticipating additional hikes every six months or so until the benchmark rate settles around 2 or 2.25 percent by the end of 2019 -- in line with the central bank’s gradualist guidance.

‘Hypothetical Scenarios’

The Canadian dollar advanced immediately after the statement was released, gaining as much as 0.4 percent, before easing back and trading down 0.2 percent at C$1.31389 per U.S. dollar at 11:41 a.m. in Toronto trading. The currency is down 1.8 percent over the past year, despite rising oil prices.

In his opening statement at a press conference after the decision, Poloz said he understands there is concern about escalation of trade tensions and acknowledged there was speculation he would hold as a result. But the governor said policy can’t be made “on the basis of hypothetical scenarios.”

Monetary policy, meanwhile, is not suited to counter all the negative effects of protectionist measures, and the effect on inflation is “two-sided,” he said. For example, a slowing economy, higher tariffs and a weakening currency could add price pressures.

“The implications for interest rates of an escalation in trade actions would depend on the circumstances,” Poloz said.

In its statement and accompanying monetary policy report, the central bank described an economy running close to capacity where higher oil prices, a weaker Canadian dollar and stronger-than- expected business investment is fully offsetting the negative effect of trade uncertainty. Exporters, meanwhile, are doing even better than previously estimated because of buoyant foreign demand.

The Bank of Canada forecast growth will average 2 percent over the next three years, unchanged from its last estimate in April and still slightly higher than what officials believe is the economy’s long-term sustainable pace. The latest growth forecasts incorporate negative adjustments that capture greater trade uncertainty.

The central bank also raised its estimates for inflation, but expressed confidence it would settle back to 2 percent after temporary factors drove the rate above target.

“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,” the bank said.

Exports, Investment

In another positive development, officials highlighted that the composition of growth is shifting away from consumption to exports and business investment -- implying they believe the expansion is more sustainable.

The increase in borrowing costs also puts the Bank Canada more in sync with the Federal Reserve and investors are now expecting the northern nation to keep track with rate hikes south of the border over the next year. The Bank of Canada has been lagging the Fed’s rate increases since oil prices collapsed in 2015 -- marking a rare divergence given how closely Canada’s economy is linked to the U.S.

Rate normalization is a delicate task for Poloz. With inflation already above the central bank’s 2 percent target and heading higher, and with financial conditions still very loose, the central bank chief needs to keep wage and price pressures in check. At the same time, moving too soon and too fast could inadvertently trigger a downturn at a time when the economy is awash in risk. And the Bank of Canada would be wary of getting ahead of the Federal Reserve should slowing global growth impact the hiking path in the U.S.

What Our Economists Say
“As expected, the BoC shrugs off the latest round of trade tariffs for now. However, should escalating trade tensions slow the Fed’s pace, loonie appreciation could tighten financial conditions and give the BoC some pause later this year,” said Bloomberg economist Tim Mahedy

Gradualism remains the order of the day however, and the Bank of Canada repeated most of the list of concerns and unknowns it has said is keeping it from an even faster normalization -- in addition to trade. Officials reiterated, for example, how the economy has become more sensitive to higher interest rates given high debt levels, which would mitigate any impulses to hike. They also believe there remains excess capacity in the labor market, with the Bank of Canada estimating that underlying wage pressures are at 2.3 percent, less than what would be expected in a jobs market that had no slack.

Policy makers are also anticipating that higher business investment will generate new capacity as companies invest to meet sales, a process the central bank has said it has an “obligation” to nurture with stimulative borrowing costs. Because business investment in the first quarter was more robust than expected, the central bank slightly increased its estimate for potential output growth in 2019 and 2020.

(A previous version of this story corrected the economist name in the breakout box.)

©2018 Bloomberg L.P.

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