In line with the analyst consensus, and in spite of the looming threat of further trade tensions with the United States, the Bank of Canada this week announced a further 25 basis point increase in its target rate. In keeping with the Bank's cautious approach, this is the first increase in six months, and it brings the target rate to 1.50 percent, the highest it has been since the financial crisis hit in 2008.
The Bank also released an updated Monetary Policy Report, and the press release introducing this report offers the best way of obtaining a quick insight into the Bank's thinking. In terms of hard economic facts, there is little new to report. The economy is operating close to full capacity and unemployment is close to a multi-decade low. Headline CPI has moved above the Bank's 2 percent target, currently standing at 2.2 percent, and all three of the Bank's favoured core inflation numbers have edged upward, to just below the target level. Although the Bank has seen a few anomalies in the recent data flow, the overall economic picture clearly supports continuation of the slow but sure policy tightening it has undertaken over the past year.
But then, of course, there is the elephant (or Trump) in the room: the incipient trade war with the United States. The press release offers an interesting insight into how the Bank is trying to take this into account. Notionally, the Bank considers that US tariffs and Canadian retaliatory measures will dampen both imports and exports, while leading to inflationary pressures that may prove temporary, but could prove more lasting. The Bank has already attempted to factor in the actual tariffs that have been imposed (steel, aluminum and lumber) into its forecast models. The economic projections on which it based this week's rate decisions take those tariffs into account as far as possible.
As for the further tariffs that Trump has threatened, especially on the automotive sector, the Bank has doubtless seen the various impact studies that have been published by banks, think tanks and others in recent weeks. No doubt, too, it has done similar work of its own. However, the Bank is not willing to base its month-to-month policy decisions on the hypothetical possibility that the US will impose tariffs on Canadian-made autos and that Canada will respond with comparable tariffs of its own.
In the circumstances this is surely the only possible approach the Bank can take, but it is worth pondering how the Bank might have to respond if the auto tariffs actually happened. Although most of the studies published so far show a major impact on the Canadian auto sector itself -- tens of thousands of jobs lost, vehicle output cut in half -- the overall first-round impact on the economy is surprisingly small: not much more than a 1 percent annual hit to GDP growth, which would fall short of pushing the economy into recession.
Given the very tight integration of the auto industries of the US and Canada (and of course Mexico), the costs of realigning production within national borders would be very high, as the US Big Three are no doubt telling the White House. The cost of vehicles would inevitably rise significantly, which would both add to inflation and crimp household spending power, with knock-on effects throughout the economy.
In such circumstances the Bank of Canada would not want to compound the problem by raising rates any further. Indeed it might deem it necessary to reverse some of the tightening it has undertaken over the past year, in the hope of engineering some weakening in the exchange rate that could help offset the impact of the tariffs. Bank of Canada Governor Stephen Poloz must hope that's a decision he never has to make.
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