As economy heats up, Bank of Canada walks a messaging tightrope

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The Bank of Canada will be walking a tightrope when communicating its rate decision this week, as rising bond yields and strong economic data have put its downbeat forecast at odds with brightening market expectations for a postpandemic recovery.

Few expect the central bank to make major changes on Wednesday when it publishes its regularly scheduled rate decision. It has repeatedly said it does not expect to raise its policy interest rate until 2023, and economists do not expect it to start slowing its pace of government bond buying until April at the earliest.

At the same time, the bank faces a communication conundrum with Wednesday’s publication – a single page document – that could send spasms through an already volatile bond market if investors take away the wrong message.

Over the past few weeks, Canadian economic data have come in stronger than the bank forecast in its January Monetary Policy Report (MPR). Gross domestic product in the fourth quarter of 2020 grew at 9.6 per cent on an annualized basis, twice what the January MPR had projected.

Even more striking, GDP grew slightly in January despite widespread COVID-19 lockdowns, according to a preliminary Statistics Canada report last week. The bank had been forecasting a 2.5-per-cent contraction in the first quarter, which now appears unlikely.

The surprisingly robust data in both Canada and the United States make the central bank’s outlook appear stale. Still, it does not have the luxury of sounding too optimistic on Wednesday, lest it send bond yields sharply higher, raising borrowing costs across the economy.

“The wrong messaging at [this week’s] policy meeting risks triggering another melt up in the Canadian [interest] rates complex,” Benjamin Reitzes, Canadian rates and macro strategist with BMO Capital Markets, said in a note.

Long-term government bond yields have been moving steadily higher since the start of the year, as markets price in a quicker economic recovery in both Canada and the U.S., owing to vaccine approvals and huge amounts of fiscal stimulus. Bond yields and bond prices move in opposite directions, and investors tend to sell longer-dated bonds when they expect faster growth, higher inflation and interest-rate increases to arrive sooner. A vigorous selloff over the past two weeks has raised the stakes for the central bank.

“The fairly straightforward solution would be to sound upbeat while indicating that substantial further improvements are still needed, but recent price action [in the bond market] leaves them little room for error,” wrote Andrew Kelvin, chief Canada strategist at TD Securities.

Markets are already expecting the bank to start raising its policy interest rate by mid-2022, Mr. Kelvin said. If this week’s message is too optimistic, markets could begin pricing in additional rate hikes over the next few years, which could raise borrowing costs and become a drag on the economic recovery in the second half of 2021.

Bank of Canada Governor Tiff Macklem laid out a possible communications path in a recent speech, in which he emphasized the labour-market component of the recovery, pointing out that unemployment remains persistently high and structural changes to the economy postpandemic may make it harder to reach full employment.

By emphasizing challenges in the labour market, the bank could acknowledge stronger GDP numbers while maintaining, as Mr. Macklem said in late February, “a complete recovery [is] still a long way off” and that “monetary policy will need to provide stimulus for a considerable period.” This employment focus echoes Federal Reserve chairman Jerome Powell, who has said the U.S. central bank will aim for low unemployment coming out of the pandemic even it means allowing inflation to exceed the 2-per-cent target for a period of time.

Most analysts expect Wednesday’s decision to be something of a dress rehearsal for the rate decision in April. At that time, the bank will publish its updated economic forecast in a new MPR. A number of analysts also expect the bank to announce in April that it is slowing its $4-billion a week pace of government bond buying.

While this week’s decision is likely less important, it will set the tone for the continuing tug-of-war between market enthusiasm and central bank caution.

“We continue to believe that both the Bank and the Fed will remain extraordinarily patient – if they are going to err, it will be by erring on the side of staying too easy for too long,” Bank of Montreal chief economist Douglas Porter wrote in a note.

“But that patience will be sorely tested in coming months as the recovery strengthens, the housing inferno continues to rage, and headline inflation drives through 3 per cent. That is a very different world than anyone could have imagined just weeks ago, let alone when things were first shutting down a year ago.”

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