Since the release of the Monetary Policy Report (MPR) on January 18th, most global risks to the Canadian outlook remain intact:
- NAFTA negotiations are expected to begin in the coming months.
- The possible rise in U.S. trade protectionism could affect the Canadian economy through various channels, notably heightened trade tensions between the U.S. and China which in turn could affect commodity prices.
- Although President Trump proposed on Monday to finance a boost in defense spending by cutting in other departments, it remains difficult to assess the impact of such measures on economic growth and interest rates.
- U.S. tax reforms likely won’t be in place before the end of the summer and the outcome remains uncertain.
- Geopolitical uncertainty is on the rise in Europe, with the formal Brexit negotiation process about to begin and spring elections in the Netherlands (March 15) and France (April-May).
- OPEC members achieved good compliance relative to the production cuts agreed to last December but it remains to be seen whether or not the deal will hold and be renewed in June.
Thus, in tomorrow’s 10AM statement providing an explanation of the policy rate decision, we expect the BoC to repeat this passage of the January statement: “Uncertainty about the global outlook is undiminished”. Domestically, some high-frequency indicators have been more constructive lately. Most notably, labour market conditions strengthened further, led by full-time, private sector job creation. However, we do not yet see broad-based strength in the Canadian economy. For instance, retail sales plunged in December (-1.0% m/m in real terms) and residential resale transactions fell by a cumulative 4.1% during the last three months. Also, manufacturing shipments rebounded during the last two months but a sustainable growth path remains elusive due to the strength of the Canadian dollar. In its January statement, the BoC noted that:
The Canadian dollar has strengthened along with the U.S. dollar against other currencies, exacerbating ongoing competitiveness challenges and muting the outlook for exports.
Also, Statistics Canada will release the December and 2016 Q4 real GDP numbers on Thursday. We expect real GDP to have advanced at a respectable clip in December due mainly to the rebound in manufacturing shipments (our call: 0.5% m/m; consensus at 0.3%; see chart below). The quarterly figure is expected to surpass the 1.5% (q/q annualized) projection assumed in the January MPR. Even if this encouraging pace of real GDP growth eliminates some of spare capacity in our economy, Canada is nowhere near the U.S. which is on the verge of closing its output gap.
Some slack definitively remains in place since the three core inflation measures are well below the 2% target (see the close link between the CPI-common measure and the output gap in the chart below). They have stabilized during the last three months (averaging 1.6%), potentially ending a disinflationary trend observed during most of 2016.
Bottom Line: In our view, it would be preferable for the BoC to keep intact its dovish rhetoric presented during the previous two decisions in January and December. Domestic economic conditions have improved somewhat, but the presence of a broad-based economic expansion remains a big question mark. And given the wide range of potential consequences from Trump’s future policies as well as new developments in Europe, Canadian economic growth could disappoint in a not-so-distant future and expand at a pace below the rate of growth of potential output (about 1.5%).
Unless the Canadian economy can escape unscathed from all the downside risks and only benefit from the upside risks, it is rather difficult for us to see at this stage how the BoC can hike its policy rate in the medium term. Thus, we continue to forecast the overnight rate target to end 2017 and 2018 at 0.50%.
