Steve Ambler is the David Dodge Scholar in Monetary Policy at the C.D. Howe Institute, and professor of economics at the school of management, University of Quebec at Montreal. Jeremy Kronick is associate director, research, at the C.D. Howe Institute.
Markets were not surprised by today’s Bank of Canada announcement to hike its overnight target rate by 25 basis points to 1.5 per cent. They had factored in a very high probability of an increase. And, consistent with a stated desire to improve its communications with both market participants and “the soccer dad,” it was a speech and a press conference that set the stage.
Governor Stephen Poloz’s speech on June 27 was an important factor in moving market expectations. By the end of the news conference that followed his speech, markets were confident of a hike. The theme of the speech was transparency and communications. By significantly shifting market expectations in the direction of a rate hike, the speech and news conference were remarkably successful in transmitting the Bank’s intentions and a good example of transparency.
But what has changed from the last announcement to cause the governing council to raise rates? The answer is simple: The things we know look brighter, and this outweighs the concern we have over the potentially bad outcomes of the things we do not.
Positive economic news abounds. Output is currently at or above potential. Last Friday’s employment data showed the Canadian economy adding almost 32,000 net jobs in June. This employment data complemented earlier labour-force-survey data that showed robust increases to average hourly earnings. Looking at global factors, the bank noted that the U.S. economy was “proving stronger than expected.”
Also critical to the bank’s decision were inflation data. Headline inflation is above the 2 percent target, with the Bank’s three measures of core inflation very close to 2 percent. Finally, oil prices have been firming up as of late, which has a net positive effect on our terms of trade and our real national income.
Given the positive data, the bank had little choice but to start moving the overnight target rate toward the “neutral” rate of interest, the rate compatible with full capacity and an inflation rate at target – which the bank estimates to be approximately 3 per cent.
But the bank, of late, has often been forced to balance positive economic news against the big elephant in the room: trade uncertainty. The business outlook survey, for example, despite the positive business sentiment, was taken before the U.S. imposition of steel and aluminum tariffs, and the explicit threat of auto tariffs. It is likely that trade uncertainty will only continue, with Wednesday’s announcement that the United States is preparing to hit China with tariffs on an extra US$200-billion worth of goods.
So the natural question is what happens if the current economic uncertainty is resolved on the down side? It is likely, then, that Canada’s economy will suffer not only from tariffs on our goods and services and from our retaliatory tariffs, but also from trade wars between economic superpowers, such as the United States and China, that disrupt global supply chains. However, with rate hikes now, the bank buys itself some breathing room if it needs it. In other words, the bank always has the option of reversing the upward march of its policy rate. And markets may, in fact, be expecting this, given a recent flattening of the yield curve.
A flattening or inverted yield curve (with long-term yields lower than short-term yields) has in the past been a predictor of trouble. Inverted yield curves have often preceded recessions in Canada, in the U.S., and elsewhere. Longer-term yields reflect both expectations of future short rates and risk. The lowering of longer-term yields in Canada may reflect market expectations that U.S. President Donald Trump will follow through with his economics-defying trade threats. If that’s the case, the extra breathing room the Bank just gave itself will help.
For now, the bank has decided to give more weight to what we know rather than what we do not. It has communicated this message effectively to markets. We now wait for the next move on the all-important trade front.