“We chose to remove the reference to the need for interest rates to return into a neutral range,” Bank of Canada governor Stephen Poloz said at a press conference on April 24. The change signals that the bank is no longer in a phase of “normalizing” interest rates.
“We feel it is important to emphasize that we will continue to evaluate the appropriate degree of monetary policy accommodation as new data arrive,” Poloz added.
As widely expected, Canada’s central bank left its overnight rate target at 1.75 percent, which remains stimulative to the economy.
Economists were suggesting that the bank could take a neutral stance to monetary policy, meaning the next rate move could either be a hike or a cut.
“I say at this point anything can happen,” said Steve Ambler, economics professor at Université de Québec à Montréal and the C.D. Howe Institute’s David Dodge chair in monetary policy.
2019 growth is now projected at 1.2 percent, down notably from the 1.7 percent forecasted in January, largely reflecting the weaker-than-anticipated fourth quarter of 2018 and first quarter of 2019. But the BoC expects growth to rebound to about 2 percent in 2020 and 2021.
“The bank’s forecast for only modestly above-trend growth in 2020 and 2021 indicates excess capacity will only be absorbed slowly—in that respect, their shift to neutral seems appropriate,” wrote RBC senior economist Josh Nye in a note to clients. RBC forecasts the 1.75 percent rate to hold through next year.
The BoC views the economic slowdown, brought on by trade tensions, last year’s drop in oil prices, and the cocktail of measures that have blunted the housing market, as almost having run its course.
Poloz called the economic slowdown a “detour” and said that, in theory, the rebound has already started. Now, the BoC is looking for proof.
“We need the data to support it,” Poloz said.
One of the brighter spots in the Canadian economy is the labour market. Rising wages support greater consumption, and outside of the oil patch, they rose by 2.6 percent in the fourth quarter of 2018.
The oil patch remains a challenged sector, with only 1.3 percent wage growth. Furthermore, the BoC expects the level of investment for 2019 to be 20 percent lower than its 2017 plateau.
As transportation capacity goes, so goes energy production and exports. The BoC expects energy exports to decline in 2019 before recovering moderately over the following two years.
The Bank of Canada used the April quarterly monetary policy report to provide updates on certain theoretical measures of the Canadian economy, such as potential output, the output gap, and the neutral rate.
Between 2019 and 2021, growth in potential output is forecast to average about 1.8 percent.
With the underperformance of the Canadian economy over the last 6 months, the output gap is estimated to be 0.25 percent higher in a range of -1.25 percent to -0.25 percent. The bank reported that the economy is no longer operating at or near full potential as it was for most of 2017 and 2018.
Similarly, the bank estimates the range for the neutral rate—an unobservable equilibrium rate that represents neither accommodative nor restrictive monetary policy—to be lower by 0.25 percent in a range of 2.25 percent to 3.25 percent. A bank analytical note stated that the lowering of the neutral rate results mainly from a “lower assessed global neutral rate.”
“It’s almost as if monetary policy has less stimulus than it did before because of the drop in the neutral rate,” Ambler said.
The bank notes that monetary policy remains stimulative to economic growth, but given its data dependency and the prolonged period of economic uncertainty, it is placing less emphasis on trending toward the neutral rate. Over the past two rate decisions, the BoC had been injecting greater uncertainty to the timing of future rate hikes.
Globally, financial markets have rebounded as central banks—principally the U.S. Federal Reserve—have backed off from raising rates. Chinese authorities have stepped up assistance to their economy with fiscal and monetary stimulus; however, the BoC expects Chinese growth to drop from 6.5 percent in 2018 to below 6 percent by 2021.
Since the bank’s last interest rate decision in January, North American stock markets are at or near record highs, 10-year bond yields are lower, and commodity prices are higher. Volatility as measured by the VIX—known as the “fear index”—has moved from 20 to about 13.
“No one is looking for a really negative outlook for the world economy,” Poloz said with reference to the stock market.
But Ambler is more concerned about what bond yields indicate.
“One thing that seems to indicate future trouble is low medium- to long-term bond yields,” he said, adding that the stocks and bonds are sending signals that seem to be hard to reconcile.
“The bond market is still a relevant place to watch how new data is processed,” Poloz said, highlighting its importance.
The bank said the phenomenon of yield curve inversions—the 10-year interest rate being lower than the 3-month rate—is less useful in anticipating recessions due to demand for government bonds instead of short-term rates rising persistently above long-term rates.
But as a hint of the relative weakness in the Canadian economy, the loonie has moved from nearly US$0.76 in January to just above US$0.74.
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