Finger on the trigger

As expected, the Bank of Canada left its overnight rate unchanged at 1.25 percent today.  However, it is clear from the statement released after the Governing Council meeting that the next rate hike will not be long in coming.

The Bank notes that headline inflation is running just above the 2 percent target and could rise further in the near term as a result of rising gasoline prices. The Bank's core measures of inflation are all close to 2 per cent, which the Bank sees as consistent with an economy operating close to full capacity.  There are signs that the economy performed rather more strongly than the Bank expected in the early part of this year: export volumes were strong, and increased imports of capital goods may be indicative of an improving outlook for business investment. 

So what's holding Governor Stephen Poloz and his colleagues back?  One factor is undoubtedly the continuing uncertainty over the NAFTA renegotiations, though in the short term this may be outweighed by the evidence that the US economy is starting to pick up steam in response to the Trump administration's tax cuts.  The biggest restraint, however, is the state of the housing market and the excessive level of household debt.

In reporting their latest quarterly results, the major Canadian banks showed little concern over the possibility that further rises in interest rates could tip increasing numbers of households into default.  Indeed, somewhat surprisingly, a number of banks have been aggressively promoting floating rate mortgages to borrowers turned off by rising fixed term rates.  Even so, there is mounting anecdotal evidence of households living payday-to-payday.  For the moment, the Bank of Canada appears to believe that the strong labour market, with unemployment at a four-decade low, will get the housing sector back on track as the year progresses, but the situation remains finely balanced.

The 1.25 percent rate target is way below anything that might be regarded as a "neutral" rate.  The Bank says it thinks a neutral level would be near 3 percent, but the combination of 2 percent-plus real growth, 2 percent-plus inflation and a tight labour market would suggest the correct level is even higher than that.  Markets are looking for a 25 basis point rate hike at the Bank's next Council meeting (July 11) and a further 25 basis points by the end of the year.  That looks about right, but would still leave the Bank with more work to do in 2019.