One small step for the Bank of Canada

The Bank of Canada raised its overnight rate target by 25 basis points to 0.75 percent today, in line with the very heavy hints dropped by Governor Stephen Poloz over the past few weeks.  This was the first upward move in rates in seven years. The press release issued by the Bank was considerably longer and more detailed than usual. Surprisingly, however, neither the release nor Poloz's opening statement to the media   made any mention of what many would consider to be the elephant in the room: the state of the housing market, especially in the Toronto area.

We'll come back to housing later, but let's focus first on the Bank's justifications for today's move.  Poloz has extolled the strength of the Canadian economy in recent weeks as he has softened up the markets for a rate move.  The Bank does not expect the 3.5 percent GDP growth rate seen in Q1 of this year to persist; it sees growth for 2017 as a whole at 2.8 percent, slipping to 2 percent in 2018 and 1.6 percent in 2019.  However, it expects the output gap in the economy to disappear by the end of 2017, considerably sooner than previously forecast.  Moreover, since the Bank sees the economy's potential growth rate as no more than about 1.5 percent, even the modest growth projected for the out-years of the forecast will trigger capacity constraints, and hence generate inflationary risks.

The imminent absorption of excess capacity in the economy is the driving factor behind today's action, but the Bank readily acknowledges that it is slightly incongruous to launch a tightening cycle while inflation is well below its 2 percent target.  Both headline CPI and the trio of core measures used by the Bank have seen inflation stuck near 1.5 percent in the last several months.  The Bank clearly believes this is driven by temporary factors, such as the electricity rebates being offered in Ontario by the increasingly desperate Wynne government. As these temporary factors wane and capacity use tightens, the Bank looks for CPI to move up to its target in 2018, with a slight overshoot of the target in 2019.  

So, what about the housing market?  All of the recent data confirm that the Toronto-area market, which was spiralling higher just three months ago, has hit a wall.  Prices have fallen sharply, listings are up and the number of transactions is down.  Ever since Governor Poloz started talking tough, personal finance experts in the media have been ramping up their warnings about how stretched some households' finances are, and urging those on floating rate mortgages to consider locking in a fixed rate.  Gov. Poloz's rate hike hints have of course been reflected in the bond market, so fixed mortgage rates have risen even ahead of the Bank's actual move.  

Given the possibility that higher rates could trigger problems for household finances, why has the Bank chosen to raise rates anyway?  The obvious answer is that the Bank has to run its policy in the interests of the entire country; it cannot allow monetary policy to be dictated by the actions of panicky homebuyers in just one market, even one as dominant on the national stage as Toronto's undoubtedly is.  Moreover, the Bank can clearly see that the long-awaited correction in the Toronto market is fully underway, rate hikes or no: the calming measures introduced by the Province of Ontario in April have had a much more rapid and profound effect than even the government itself can have expected.  

Despite the lack of focus on it in the Bank's statements today, there can be no doubt that the reaction of the housing market will play a major part in the Bank's thinking as it ponders its next move.  Gov. Poloz described the Bank's stance this way:

Governing Council acknowledges that the economy may be more sensitive to higher interest rates than in the past, given the accumulation of household debt. We will need to gauge carefully the effects of higher interest rates on the economy.

Future adjustments to the target for the overnight rate will be guided by incoming data as they inform the Bank’s inflation outlook, keeping in mind continued uncertainty and financial system vulnerabilities.

Data-dependent, then, as always.  Markets appear to be looking for one more 25 bp hike this year, with a further 50 bp to follow in 2018.  That looks about right, and would still leave rates well below historically normal levels.