The Bank of Canada left its reference rate unchanged at 1.25 percent today, in line with market expectations. The Bank's Governing Council continues to believe that "higher interest rates will be warranted over time". However, it stresses that the sensitivity of the economy to interest rate movements means that it will "remain cautious with respect to future policy adjustments, guided by incoming data". This language has been interpreted as slightly dovish by the markets, with the result that the Canadian dollar has weakened marginally.
Recent data have tended to cloud the policy outlook somewhat. After a strong performance during 2017, real growth slowed markedly during the first quarter of this year. In the meantime, inflation at the consumer level has been edging higher for many months, with the Bank's favoured core measures at or above the 2 percent inflation target.
Looking ahead, the Bank expects that GDP growth will rebound in the current quarter, resulting in an average pace of 2 percent for the first half of the year. This pace is expected to continue through 2019, before a very slight slowdown in 2020. The Bank characterizes this growth rate as "slightly above potential". However, it is worth noting that the Bank has upwardly revised its estimate of potential growth, which implies that it is somewhat less concerned about the risks of the economy overheating in the near term.
As for the inflation outlook, the Bank foresees CPI running slightly above the 2 percent target this year, before edging back down to the desired level for the next two years. This view reflects a belief that the impact of one-off factors, such as higher gasoline prices, will soon fade. A key consideration in terms of the inflation outlook is the direction of earnings. With unemployment hovering at multi-decade lows, wage pressures have been increasing, but the Bank seems relatively unconcerned at this stage, calling the recent data "encouraging".
So, what's next? Introducing the Bank's quarterly Monetary Policy Report, Governor Stephen Poloz noted that the Bank's estimate of the neutral policy rate, given inflation of 2 percent, lies between 2.5 and 3.5 percent. He also pointed out that the current rate is negative in real terms. This implies that the tightening cycle has a long way to go. However, the Bank continues to believe that monetary policy will have to remain accommodative because of structural issues, notably the bloated level of household indebtedness.
It remains likely that a further 25 basis point rate hike will come at one of the next two policy meetings (May and July), not least because the Bank cannot afford to be seen sitting idly by as inflation edges further above its target. The cautious tone of today's statements suggests there will be no more than one further rate hike in the second half of the year, and possibly not even that. With the Fed set to raise rates at a somewhat faster pace, this means that the exchange rate is likely to trend gently lower.
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