There is by now no doubt that the Bank of Canada is keen on sending interest rates higher. Governor Stephen Poloz has been clear: notwithstanding “hypothetical scenarios,” such as the dissolution of the North American free-trade agreement, “higher interest rates will be warranted to keep inflation near target,” he said on July 11, in the wake of the Bank hiking rates by 25 basis points.
We know rate normalization is heading our way. The big question isn’t whether rates will rise; it’s when. As the Sept. 5 Bank of Canada announcement approaches, it’s important to remember “near-certainty” doesn’t necessarily mean “now.” We think the bank should – and will – continue on a very gradual path toward policy normalization, and defer hiking rates until at least October.
Granted, the economic data have been coming in hot. July inflation was 3 per cent, well above economist expectations of 2.5 per cent. Second-quarter GDP growth has been tracking around 3 per cent, which is slightly above the bank’s estimate. Meanwhile, the evolution of growth seems to be following Mr. Poloz’s preferred script: exports and investment are strengthening while consumption growth has been slowing.
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So why wait? There are a few reasons, adding up to this: The Canadian economic recovery is uneven, and the underpinnings of future growth look less stable than they did a few months ago.
- Inflation is (still) subdued: This might seem strange, given July’s breakout number. But that was headline inflation, probably boosted by transitory price increases for travel and gasoline. Importantly, the core measures, which better-indicate underlying inflation trends, were unchanged or up only marginally, averaging out at 2 per cent. It’s likely the July reading is more indicative of the past, with four of the five key inflation risks the bank identified in its July Monetary Policy Report pointing down. In short, inflation doesn’t look to be a mole in need of imminent whacking;
- Household debt is (still) high: Higher rates have begun to slow credit expansion. The household debt ratio now stands at 170.2 indicating consumers owe $1.70 for every dollar of disposable income. That is extremely burdensome, and it’s creating a delicate balancing act for the central bank. While some consumption-growth braking is expected and even desired, quick rate increases could cause demand to slow too much, too fast, sending consumption into free fall.
- Trade growth might be capped: Notwithstanding unresolved NAFTA renegotiations and festering disputes with the United States, recent trade data have been strong, thanks largely to rising oil prices. That’s all good. However, if such is the trend for trade growth, we would need to see higher oil prices and/or higher export volumes. On that front, a cautious view is warranted for two reasons: the inability to ramp up pipeline capacity and nascent signs of slowing global trade – the S&P GSCI commodity index, a broad measure of commodity prices, is currently down more than 7 per cent from its May peak.
- No employment pressure: The unemployment rate has fallen to 5.8 per cent – the lowest since the 1970s – and the headline data from July looked strong, with 54,000 new jobs. Over the past year, the Canadian economy was adding an average of 20,000 jobs a month. However, in all of 2018, job creation has slowed markedly, to just 3,000 jobs a month. So, while unemployment is low, there is nothing to suggest labour force pressures are building. With part-time jobs growing at the expense of full-time positions, there is also no real indication of growing wage pressure – a key downside risk to the bank’s inflation outlook.
- Global uncertainty is rising: Trade tensions have already begun to undermine global economic relationships. We still expect above-trend global growth, but it won’t be evenly distributed. While the United States is surging (for now), China’s growth trajectory has cooled. Europe, Japan and emerging markets are flagging, and it remains unclear how long this divergence can last or how it will be resolved.
- Market signals are flashing yellow: The yield curve – in both the U.S. and Canada – is flattening. History suggests that when the difference between short- and long-term rates is near zero or negative, a reversal of the economic cycle is around the corner. We’re not there yet, and we don’t believe a recession is imminent. Yet, the curve is signalling that the risk of monetary policy error is on the rise. In our view, the market is hinting that if central banks accelerate the pace of normalization, they could be driving their economies into a brick wall.
Put it all together, and we believe that while the Bank of Canada’s path to normalization is well defined, it will remain gradual. For that reason, we expect a pause on Sept. 5.
Aubrey Basdeo is head of Canadian Fixed Income at BlackRock Asset Management Canada Ltd.