Bank of Canada Holds Rates Amid Nafta Negotiations

(Bloomberg) -- The Bank of Canada indicated it’s ready to continue hiking interest rates, but is holding off to see what happens with Nafta negotiations.

The Ottawa-based central bank left its overnight benchmark interest rate unchanged at 1.5 percent on Wednesday, as expected by 20 of 21 economists in a Bloomberg survey, while reiterating “gradual” hikes will eventually be warranted because the economy is at capacity.

The statement introduces language, in the key final sentence, that acknowledges the accelerated pace of developments in negotiations currently underway in Washington to revise the North American Free Trade Agreement. It remains unclear whether Canada will join a deal the U.S. has forged with Mexico, or be left out.

The Bank of Canada is “monitoring closely the course of Nafta negotiations and other trade policy developments, and their impact on the inflation outlook,” it said.

An agreement would clearly give Bank of Canada Governor Stephen Poloz more comfort in pressing ahead with a hiking cycle that has already seen the central bank raise borrowing costs four times since mid-2017. A collapse of talks would cast doubt on those plans.

More Increases

Investors are anticipating as many as three more increases over the next year, starting with a move at the central bank’s next decision in October.

“Discretion is the better part of valor, so a Bank of Canada potentially only days away from getting some clarity on Nafta was wise enough to defer the next rate move until that news was at hand,” Avery Shenfeld, chief economist at CIBC World Markets, said in a note to investors. “An October rate hike looks highly likely if, as we expect, we have the makings of a Nafta deal by then.”

Outside of trade, the Bank of Canada painted a picture of an economy that is doing well enough to require higher rates. According to the statement, Canada’s economy has been operating at near capacity “for some time,” business investment and exports have been growing “solidly for several quarters,” the housing market is stabilizing, financial stability risks are moderating and employment gains are supporting consumption.

Policy makers also removed phrasing that has appeared in the last seven decision statements about monitoring the “evolution of capacity,” possibly a nod to the central bank’s increasing confidence that economic slack has dissipated.

What Our Economists Say

The September statement was potentially more hawkish than some interpreted, and the likelihood of another rate hike later this year or early in 2019 is underestimated by market participants. Yet, a breakdown in Nafta talks is a serious threat to Canada’s economic expansion and would scuttle the BOC’s plans for gradual removal of policy accommodation.

-- Tim Mahedy, Bloomberg Economics
Read more for the full reaction note.

“Recent data reinforce Governing Council’s assessment that higher interest rates will be warranted to achieve the inflation target,” the bank said,

At the same time, there are few signs of worries about overheating or sense of urgency in hiking rates. The central bank downplayed the significance of July’s inflation spike, saying it expects readings to move back towards 2 percent early next year as the impact of higher gasoline prices wane, with core inflation “firmly” around 2 percent.

Wage growth is “moderate” and the economy is “evolving closely in line” with the central bank’s projections at near its potential growth rate.

The central bank also reiterated it is monitoring the economy’s “reaction” to higher interest rates -- a key concern that Poloz has been flagging for a while given the country’s high debt levels and seen as a reason to remain cautious.

The Bank of Canada also commented on recent “financial” stresses in emerging markets, but said those are expected to have “limited spillovers”.

The Canadian dollar briefly reversed gains after the decision was released, before trading little changed at C$1.3179 against the U.S. dollar at 10:10 a.m. Toronto time. The yield on Government of Canada 2-year bonds rose 1 basis point to 2.06 percent.

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