Stephen can't wait

By the time the Bank of Canada's rate decision was announced by Gov. Stephen Poloz this morning, financial markets were pricing in a better-than even chance of a rate hike.  In contrast, a majority of business economists did not expect the Bank to move until October, when it is due to release its updated economic outlook.  One-nil to the market, then: the Bank raised its overnight rate target by 25 basis points to 1 percent, the second such increase this year.

The Bank's press release indicates that it made the move today in response to the steady flow of strong economic data, most notably the remarkably robust Q2 GDP numbers released last week. Earlier this year the Bank surprised markets by suggesting that the economy would reach effective full capacity by the end of this year.  Today's statement notes that GDP is now higher than the Bank had expected, which implies that we may already be almost at full capacity.  Although the Bank expects the pace of growth to slow in the second half of the year, and although it still sees some surplus capacity in the labour market, it clearly opted for an early move to avoid "falling behind the curve".

Remarkably, Canadian financial markets are now pricing in more tightening by the Bank than is currently priced in for the US Federal Reserve.  At least three more rate hikes are now expected, with one of them coming before the end of this year.  The Bank's release today is careful to note that further moves will be data-dependent, and there are at least two factors that should deter it from moving too quickly.

First, the economy's growth is heavily reliant on consumer spending, which makes up 64 percent of GDP.  Consumer debt, already at record levels, continues to grow, and it is hard to know the point at which even moderately higher rates might cause consumers to ease back on their spending.  Second, the prospect of higher rates is pushing the exchange rate ever higher: after this morning's announcement it spiked above 82 cents (US), its highest level in more than two years.  The Bank is anxious to see a higher level of export growth and will not want to see the currency strengthen unduly.

All of that said, more rate hikes are surely coming, with the next move probably in October.  The hand-wringing from financial experts about the problems that will be caused for households is already at a fever pitch.  Those of us old enough to remember a time when the Bank Rate was in double digits and rates would move around by a percentage point at a time can be forgiven if we feel slightly bemused by this.