E Do Not Read Too Much In The Likelihood Of A Rate Hike In Canada

When Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, gave an upbeat review[1] of the economy earlier this week, currency and bond markets started to factor in a rate hike. The Canadian dollar jumped  just over 1 per cent and the 10 yr bond yield backed up about 10 bps. Her comments have been interpreted as a major shift in policy towards tightening.  Are these markets reading too much into Wilkins’ statement?

To begin with, Wilkins argued that Canada is experiencing a “more broad-based economic growth which makes it more likely that it will be sustainable over the medium term.” Furthermore, the Bank sees signs that the adjustment to much lower oil prices is now well underway and that should lead to an improvement in capital expenditures. Business investment has been very poor since oil prices collapsed in 2014 and that has been a major drag on economic performance. Overall, the Bank is encouraged by growth in several important sectors as well as a general improvement in job creation.

Traders should not, however, lose sight of the key factor that determines rate policy: namely inflation and inflationary expectations. Wilkins was quick to point out that: “While broad-based growth is desirable, it’s not under the direct control of monetary policy, and it’s not our objective. We target a 2 per cent inflation rate.”

In fact, the Bank aims to contain inflation in the 1 to 3 per cent range. As the accompanying chart shows, the total CPI is 1.6 per cent i.e. in the middle of the target range. Inflation would have to move up considerably to provoke the Bank to withdraw current monetary stimulus.

The primary reason that inflation remains low is that there continues to be a significant “output gap”; that is total resources—labor and the capital stock— are not fully utilized. Until that the output gap is much closer to being closed, inflationary pressures will be subdued. Wilkins makes it clear that: “slack in the economy is still translating into below-target inflation and hence the risks to the outlook remain”.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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