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Bank of Canada Governor Tiff Macklem has said markets become impaired once central banks own between 50 per cent and 70 per cent of the bond supply.

Chris Wattie/Reuters

The Bank of Canada is expected to reduce its pace of federal government bond buying this week in response to an improving economic outlook, while maintaining a cautious tone amid soaring COVID-19 cases and heightened lockdown measures in Ontario.

Most analysts are forecasting a $1-billion cut to the central bank’s weekly bond-buying program – also known as quantitative easing, or QE – in its rate decision on Wednesday. The bank is currently buying at least $4-billion worth of federal government bonds each week in an effort to keep benchmark interest rates down and stimulate borrowing.

There is less consensus on what the bank will say about timing for interest-rate hikes. Since October, the bank has maintained that it does not expect to raise its overnight policy rate until 2023. However, with recent GDP and employment data coming in stronger than anticipated, the bank may decide to shift its forward guidance for a rate hike to 2022.

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“What makes this really interesting is that we have this sort of last-minute twist with additional public-health restrictions coming in Ontario,” said Andrew Kelvin, chief Canada strategist with TD Securities.

Wednesday’s decision will be delivered alongside a new Monetary Policy Report (MPR), a quarterly publication where the bank lays out its latest economic projections. Things have changed significantly since the January MPR.

Annualized GDP growth in the fourth quarter of 2020 was twice what the bank projected in January, while GDP growth in the first quarter of 2021 did not contract as the bank had predicted, despite a second wave of lockdowns. Commercial bank economists now expect Canada’s GDP to grow by around 6 per cent in 2021, two percentage points higher than projected in the January MPR.

These changes underpin the argument for tapering QE this week. Members of the bank’s governing council have said repeatedly they will reduce the size of the QE program as they gain confidence in the recovery. They have also said any wind-down of the program will be gradual.

“My expectation is that the positive surprises we’ve seen over the last three months in the GDP figures, in the labour market, business confidence and the housing market, those should outweigh any concerns they may have around the impact of a third wave of COVID,” Mr. Kelvin said.

There are also technical reasons for the bank to trim its bond-buying program this week, said Benjamin Reitzes, Canadian rates and macro strategist at BMO Capital Markets.

Having purchased billions of dollars worth of Government of Canada bonds every week for the past year, the bank owns more than 40 per cent of the market. Bank of Canada Governor Tiff Macklem has said markets become impaired once central banks own between 50 per cent and 70 per cent of the bond supply.

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With the federal government expected to dial back emergency pandemic programs over the coming months, it will likely issue fewer bonds to finance the spending. That means the bank needs to slow its pace of buying in line with the lower issuance so it does not end up owning too much of the market.

“I think they’re very cognizant of that, and they just want to make sure that they don’t do anything to impair the functioning of the market beyond what’s absolutely necessary,” Mr. Reitzes said.

The wildcard on Wednesday is the bank’s forward guidance for rate hikes. The bank has said it won’t raise rates until slack in the economy is absorbed and inflation is sustainably hitting its 2-per-cent target. In its January MPR, the bank said this likely won’t happen until 2023.

With COVID-19 vaccination picking up pace, the “output gap” – the difference between what Canada can produce and what it does produce – could close earlier than 2023, putting upward pressure on inflation. But output-gap calculations are based on moving variables, said Royal Bank of Canada rates strategist Simon Deeley.

For instance, the bank is expected to raise its projection for potential output growth on Wednesday, after slashing it in October; that would mean it believes the economy has more room to grow before substantial inflationary pressures emerge.

Moreover, the relationship between the output gap, employment and inflation is neither linear nor easy to predict, Mr. Deeley said.

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“If the bank has slack absorbed in 2022, which based on the numbers, they should ... they may not have the second condition, which is inflation is sustainably at the 2-per-cent target,” he said.

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