BoC faces brighter, but incomplete picture in rate decision

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The Bank of Canada goes into an interest-rate decision this week looking at an economy that's a little more upbeat than when it made its close call in January to keep rates steady.

But the bank still lacks some critical information on just what kind of economic cards it will be dealt this year – particularly the ace in the hole being held by its crosstown counterparts in the federal government. The central bank will issue the latest of its eight-times-a-year rate announcements on Wednesday, and the overwhelming majority of observers expect the bank to hold its key rate steady again at 0.5 per cent. Critically, the rate decision comes about two weeks before the new Liberal government unveils its first federal budget – a budget that promises significant new infrastructure investment and a general loosening of the purse strings, aimed at giving a government-funded lift to Canada's economic prospects over both the short and longer term.

In its last rate decision, in January – a decision that many experts thought might be the bank's third rate cut in a year in support of the ailing economy – the bank instead signalled that it was in a holding pattern until Ottawa makes clear just how much fiscal stimulus it plans to inject into the struggling economy. Without knowing the government contribution to economic activity, the central bank is only guessing at how fast it can expect the economy to grow this year, and that makes it hard to chart a firm course for monetary policy.

Meanwhile, the economy has shown a bit more life since that January decision. Last week's fourth-quarter gross domestic product report estimated that real GDP grew at a 0.8-per-cent annualized rate, compared with the bank's estimate of zero in its January Monetary Policy Report (MPR). The better-than-expected momentum entering 2016 also suggests that first-quarter growth could well top the bank's forecast of 1.0 per cent annualized.

That alone could be enough to allow the central bank to comfortably stand pat in this week's rate decision, while it awaits the budget.

Nevertheless, the lukewarm growth still leaves us with a picture of an underperforming economy that's growing too slowly to absorb its excess capacity.

In the minds of some observers, the prospect of this excess (known as the "output gap") persisting, even widening, in 2016 implies that the Bank of Canada should be seriously thinking about further rate cuts. Even once the federal government commits to its spending plans, much of the promised infrastructure investment will come too slowly and/or too late to give this year's growth much of a lift. And with plenty of spare capacity in the economy, it's hard to see much pushing inflation upward, beyond the weak Canadian dollar.

But the reality, one the Bank of Canada is well aware of, is that while energy, a relatively small part of the Canadian economy, has performed alarmingly poorly, the majority of the economy is doing just fine.

In January's quarterly Monetary Policy Report, the bank included a special box in which it discussed the "complex and lengthy adjustment" that the Canadian economy is going through as a result of the plunge in oil and commodity prices. (When the Bank of Canada goes to the trouble to put a report in a special box in its MPR, it's something the bank considers particularly germane to the policy discussion.) It highlighted the enormous divergence in economic performance between the energy-producing provinces and the rest of the country since the oil shock began in late 2014. By almost any measure, the non-energy provinces have been thriving.

"The Canadian economy still has a doughnut hole in the middle, but there's some fresh icing on the rest of it," Canadian Imperial Bank of Commerce chief economist Avery Shenfeld said in a research report.

A key reason has been the Canadian dollar, which fell sharply as the deep declines in commodity prices eroded Canada's terms of trade. The Bank of Canada has long held that the lower currency would spur exports in non-resource goods and services, providing a critical avenue to the economy's recovery. Friday's international merchandise trade report from Statistics Canada indicated that those non-resource exports continue to evolve much the way the Bank of Canada had hoped.

January's non-energy exports were up 2.3 per cent from December, and more than 15 per cent from the same month a year earlier. On a cumulative basis, non-energy exports rose nearly 10 per cent over the past 12 months.

Meanwhile, oil prices have come back from the precipice, and the Canadian dollar has pulled out of its nosedive and recovered considerably since mid-January – easing what had become an increasingly ominous threat to Canadian consumer confidence.

Still, that recovery in the loonie – which was aided by the Bank of Canada's close-call decision in January to resist another rate cut – may remove some of the currency fuel from the non-resource economy. The Bank of Canada will want to choose its words carefully around the currency in the rate announcement; it has little interest in encouraging the dollar's rally and undermining the currency's support of an export-led recovery.