Overheating Economy Tests Poloz's Patience With Canadian Rates

(Bloomberg) -- The biggest threat to Canada’s economic expansion lies within its own borders, even as President Donald Trump pushes protectionism from abroad.

The home-grown news is that the Canadian economy is closer to overheating than faltering on the back of the trade uncertainty, forcing the Bank of Canada to respond with higher interest rates.

Statistics Canada is expected to report Thursday that growth accelerated to an annualized 3 percent or more in the second-quarter, the fastest pace in a year. That should offset a weaker start to 2018 and puts the expansion on track for a gain of more than 2 percent for the whole year after 2017’s strong 3.1 percent advance.

Such robust demand is exposing how little spare capacity the economy has. Companies are running up against production constraints and labor shortages, while an inflation rate of 3 percent is the highest in the Group of Seven.

“Trade uncertainty is on everyone’s mind but demand is strong and so for a number of our clients labor is a bigger issue, and it includes both finding qualified skilled labor as well as upward pressure on labor rates,” Royal Bank of Canada Chief Financial Officer Rod Bolger said in a telephone interview last week.

Evidence Abounds

The evidence of tightening is everywhere: the unemployment rate is sitting at four-decade lows; pay raises are picking up; and companies are reporting increasing number of job vacancies. Job listings show businesses giving thousands of dollars in signing bonuses to hairstylists and mechanics.

At the same time, Canada now relies entirely on immigrants to grow its workforce as the population ages. According to Statistics Canada, the number of landed immigrants in the labor force in July was up by 164,000 over the previous 12 months, and down 72,000 for people born in Canada.

Economists including those at the Bank of Canada estimate the nation’s economy can’t grow more than 2 percent before inflation kicks in. Which is why the big question for financial markets right now is not how fast the expansion runs, but how quickly rates rise and by how much.

“Just about every firm I talk to is talking about labor shortages,” said Jean-Francois Perrault, chief economist at Bank of Nova Scotia. “The labor issue is a dominant issue facing businesses right now.”

To be sure a breakthrough on trade would help ease some of those capacity constraints. While companies can’t do much about demographics, they can find ways around labor shortages by buying more equipment and adopting new technologies. More certainty on trade should bolster their confidence and willingness to invest, and make them willing to offer higher wages to draw more people into the labor force.

No one though is expecting another investment renaissance in Canada that could change the overall growth trend, partly because companies are wary of overextending themselves in an economy that’s slowing down.

Prime Minister Justin Trudeau’s willingness to increase immigration will help, but this too is increasingly becoming a politically contentious issue. More immigrants are also no panacea, since evidence suggests they may be less productive than the workers they replace.

All this may leave companies struggling to keep up with demand in the future, potentially fueling inflationary pressures.

Overheating Economy Tests Poloz's Patience With Canadian Rates

Investors see near-certain odds that by October, the Bank of Canada will raise borrowing costs for a fifth time since the hiking cycle began in July 2017, with as many as two additional increases by mid-2019.

The central bank’s own models say it’s behind the curve on normalizing borrowing costs from historically low levels, but Bank of Canada Governor Stephen Poloz has stuck to a gradual path in the belief there’s still some slack in the labor force, particularly among youth and women, that could be drawn in with lower rates.

Economists also don’t unanimously agree that supply is the major bottleneck in advanced economies like Canada. It may be that companies aren’t investing in capacity because demand is being weighed down by other things like unequal distribution of wealth or a debt overhang. If demand is the problem, rate hikes may not be the solution.

But the Bank of Canada’s options are limited, given its prime mandate is to tackle inflation, not structural problems such as income inequality or production constraints. And with inflation already a full percentage point above the 2 percent target, Poloz’s patience is being tested.

©2018 Bloomberg L.P.