Easing up on the gas

As expected, the Bank of Canada left its key overnight interest rate unchanged at 0.25 percent after today's Governing Council meeting. However, it signalled its confidence in the continuing recovery of the economy by cutting its weekly bond buying (QE) program to C$ 2 billion from the current C$ 3 billion. The Bank also issued an updated Monetary Policy Report in which it offered more detail regarding its forecasts for growth and inflation. 

GDP growth in the first half of this year has been slightly below the Bank's earlier expectations, reflecting the impact of the most recent round of COVID restrictions at the provincial level and supply chain issues affecting the global economy.  However, with restrictions easing again and Canada's vaccination program powering ahead, it expects faster growth in the second half of this year and beyond. Its real growth projection for 2021 as a whole is now 6 percent, marginally below its earlier forecast, but it now expects further growth of 4.5 percent in 2022, higher than previously expected, tapering slightly to 3.25 percent in 2023.

The key issue these forecasts raise for policymakers is, how quickly will surplus capacity in the economy be absorbed, raising the risk of increased inflationary pressures?  The Bank notes that estimating the degree of slack is always difficult and has only been made more so by the impact of the pandemic.  It still projects that slack will be absorbed by the second half of 2022, but intends to follow a wider range of indicators over the coming months so as to keep a close eye on this. It will pay particularly close attention to labour markets, which is potentially significant given that the job market has so far recovered more slowly than real output. 

Given the Bank's focus on its 2 percent inflation target and its commitment to maintaining stimulative policy until actual inflation is sustainably at that level, this growth outlook seems to keep the Bank's plan not to raise rates until late 2022 intact. However, in Canada as in the US, the latest inflation readings have been well above the target. The Fed has continued to express confidence that above-target inflation in the US -- above 5 percent in June -- is transitory, and the Bank believes the same is true for Canada.  

The Bank sees the current uptick in inflation to 3.6 percent in May (June data will be not be available until July 28) as attributable to three main factors. First, gasoline prices plummeted at the start of the pandemic but have now bounced back to and above their pre-pandemic levels, producing the so-called base effect on CPI measures. Second, other prices that fell in the early stages of the pandemic are now recovering. Third, supply chain issues throughout the global economy have pushed up prices for a range of goods from semi-conductors to cars to lumber.

There are signs that some of these supply chain issues, especially for lumber, are easing, but it is much less obvious that upward pressure on gasoline prices will wane any time soon. It has to be said that the Bank's definition of "transitory" has taken on a little more flexibility. Previously it expected CPI to head back to the target level by the end of the summer, but it now expects it to be above target for the rest of this year and to move back towards 2 percent in 2022.

For now, it appears that bond markets are happy to take the Bank's word for it. Futures markets are showing no expectation of any rate moves until at least the third quarter of 2022. That said, the CPI figures that will appear at the end of this month will be well worth watching.