The Bank of Canada left the overnight rate target unchanged at 1.00% Wednesday. Our interpretation of the statement is that BoC officials maintain a very prudent tightening bias.
“While higher interest rates will likely be required over time, Governing Council will continue to be cautious, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.”
Basically, the statement echoes governormCarolyn Wilkins’ dovish speech made Nov. 15th.
Regarding “the economy’s sensitivity to interest rates,” it is too early to precisely assess the magnitude of the impact of last summer’s 50-basis-points policy rate increase on households’ financial situation. There is a fair chance the household-debt-service-to-disposable-income ratio increased slightly for the first time in the current business cycle during the second half of 2017, after being fairly stable near 14% since 2010. Households will likely be able to partially absorb higher interest rates in 2018, or completely if wage growth surprises consistently on the upside.
In this statement, the BoC was right to acknowledge the recent improvement regarding wage inflation. According to the LFS report released last Friday, average hourly earnings in November accelerated to 2.7% on a year-over-year basis, doubling the pace of growth registered last summer. Still, the cautious BoC does not overreact to the recent strength in some labour market indicators: “Meanwhile, despite rising employment and participation rates, other indicators point to ongoing – albeit diminishing – slack in the labour market.”
For instance, the October MPR referred to subdued growth in unit labour costs.
Regarding “the evolution of economic capacity,” the BoC continues to see the economy running close to its potential following last Friday’s release of the 2017Q3 GDP report. One progress mentioned by the BoC was the increasing pace of public infrastructure spending and private business investment, contributing to make the recovery more sustainable. At the same time, the GDP historical revisions showed an improved profile for non-residential investment in recent years, implying a higher potential GDP. Altogether, the Canadian economy appears far from being at risk of overheating. Based on a simple analysis, we find that a smaller-than-usual share of the 173 CPI subcomponents rose above the 2% target in 2017 relative to 2016 (34%). If this trend continues, it will be difficult for CPI inflation to rise materially in 2018-19. Furthermore, a higher-than-usual share of CPI subcomponents declined in 2017 versus 2016 (38%).
This apparent broad-based weakness in the CPI could be related in part to two global structural factors that were mentioned in the previous October statement: digitalization and globalization. These two global structural forces could restrain inflation in the long run. In the short run, it will take a major positive surprise, such as the removal of NAFTA uncertainty, for the BoC to consider hiking at the Jan. 17 meeting. Thus, at the earliest, we can see the BoC raising its policy rate by 25 basis points at the March 7 meeting. Our year-end 2018 forecast for the overnight rate target is still 1.25%.
Bottom Line: The two 25-basis-points policy rates hikes of 2017 can be seen as picking low-hanging fruit. In 2018, increasing the overnight rate target above 1.00% will be a lot more challenging.
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