The Bank of Canada increased its overnight rate target from 1.25% to 1.50% yesterday. The 1.50% policy rate is still low compared with the current 2% CPI inflation rate. Thus, the BoC is maintaining its gradual tightening bias: “Governing Council expects that higher interest rates will be warranted to keep inflation near target and will continue to take a gradual approach, guided by incoming data.”
Markets interpreted this passage of the statement, among others, as hawkish. The market was expecting a dovish hike and was a bit surprised by the confidence of the bank. However, the trade war risks were acknowledged. As such, the Canadian dollar gained following the bank’s decision only to recede during the press conference that followed.
In the July Monetary Policy Report (MPR), Canadian real GDP annual growth is still projected above potential output overtime, thanks to a stronger-than-expected U.S. economy and higher crude oil prices. These positive developments offset the assumptions of a larger drag on Canadian investment and exports coming from trade uncertainty and a modest negative impact coming from tariffs on steel and aluminum imposed by the White House a few weeks ago. Escalation in the global trade war, still a real possibility, would, however, change the outlook.
Thus, on the one hand, economic conditions could warrant another 25 pbs policy rate hike, at the Oct. 24 or Dec. 5 meeting. The timing of the next policy rate hike will continue to depend on the data: “In particular, the bank is monitoring the economy’s adjustment to higher interest rates and the evolution of capacity and wage pressures, as well as the response of companies and consumers to trade actions.” For instance, the BoC will pay close attention to how it may change the supply chain. On the other hand, an escalating trade war scenario would yield a much more prudent policy reaction.
Bottom Line: The maturity stage of the business cycle underpins the cumulative 100-basis-points increase in the overnight rate target observed since July 2017. Under normal circumstances, we would say that the BoC is, by now, mid-way through its gradual tightening cycle. But an escalation in the global trade war could prompt the BoC to change course even though monetary policy actions alone should not be seen as a magical cure to an intensifying trade spat. If the Trump administration moves swiftly to implement auto tariffs for instance, a lower policy rate could even be required before year-end.
In contrast, if the trade threat recedes before the U.S. mid-terms and a constructive NAFTA deal is in the cards for early 2019, the overnight rate target could easily end up at 1.75% before the year is over.