Despite an unexpected decline in the headline CPI inflation in September, from 2.8% to 2.2%, core measures of inflation held on at around 2.0%. This modest acceleration in core CPI measures and the maintaining of a positive economic momentum above potential are key arguments supporting a 25-basis-point hike by the Bank of Canada this Wednesday. Financial markets widely expect the overnight rate target to increase from 1.50% to 1.75% as 95% of a rate hike is currently reflected in interest rate swaps.
Along with its interest rate announcement, the BoC will also publish a new Monetary Policy Report (MPR) containing a revised economic outlook. At best, we think the Canadian real GDP growth forecasts could be modestly revised upward in the October MPR relative to the July edition. Indeed, plenty of new elements need to be incorporated in the forecast.
First, the massive $40-billion LNG project recently announced in B.C. will significantly boost non-residential construction activity in the coming years, starting in 2019. This could add as much as 0.2 percentage points to annual real GDP growth. Second, the USMCA deal finally puts an end to most domestic trade uncertainty. This should contribute to a small improvement in Canadian exports and business sector forecasts. For instance, in its prior forecast, the BoC subtracted 0.7 ppt from Canadian growth by the end of 2020 to account for trade uncertainty.
This being said, investors expecting a hawkish BoC on the basis that trade uncertainty is lifted once and for all could be disappointed. Indeed, the U.S. recently imposed 10% tariffs on $200 billion of Chinese goods, which was obviously not accounted for in the July MPRbase-case scenario. This may lead the BoC to revise down a notch its global real GDP growth forecast in a similar way that the IMF did earlier this month (from 3.9% to 3.7% for both 2018 and 2019).
Third, the BoC mentioned in its Sept. 5 statement that the escalating trade tensions started to weigh down on some commodity prices. Given that the decline in non-energy commodity prices has since continued, we think that the central bank could factor in a greater global negative trade impact in its new projections.
Finally, the BoC will include in the new MPR Outlook higher-than-expected WTI prices and, more importantly, a much lower price for the Western Canadian Select (WCS). By convention, the BoC assumes that oil prices will remain near their recent levels. WCS prices averaged close to US$31/bbl during the last month, significantly below the US$50 assumed in the July MPR. Using depressed WCS prices as an assumption could turn out to put the bar too low for other policy rate increases in 2019 as WCS could rapidly rebound. As we argued in a recent report, the record-high US$50 discount registered last week reflects mostly a combination of temporary factors and is unlikely to persist.
Bottom Line: The BoC would be right to keep its “gradual” tightening process data-dependent and saying that “higher interest rates will be warranted to achieve the inflation target.” Finally, since the overnight rate target is lower than the Fed funds rate target and that the White House may increase tariffs on Chinese goods to 25% in January 2019, it would be surprising in our view if the BoC hinted to the necessity of shifting its hiking cycle into high gear. Moreover, the central bank has been emphasizing the “economy’s reaction to higher interest rates” in each of its fixed announcement date since September 2017. In our view, the BoC considers the current environment of high household indebtedness and housing market imbalances as important vulnerabilities that would trigger larger-than-expected negative shocks to growth and inflation if interest rates were to increase too quickly (for example, see this BoC’s research note). All in all, we currently forecast a 25-basis-point policy rate increase in 2019 Q1 followed by another one in 2019 Q3. Yet, the risk is tilted towards three hikes for the entire 2019 rather than only one as long as the current expansion continues without any major incident.