Business investment has emerged as the single biggest uncertainty looming over the Bank of Canada’s path to higher interest rates.
On Wednesday, the central bank decided to hold its key interest rate steady at 1.25 per cent for the time being, while making it abundantly clear that it still plans on raising rates further, on top of its three quarter-percentage-point increases in the past nine months. The question is not if, but when – and that’s anyone’s guess. Including, it appears, the central bank’s.
“The pace is a significant question mark for us,” Bank of Canada Governor Stephen Poloz told a news conference after the bank’s release of its rate decision and quarterly Monetary Policy Report. “We can’t be definitive about when, or at what pace.”
One thing that is clear is that business investment has become central to answering that question.
Perhaps the most interesting development in the central bank’s update was its revelation that Canada’s output gap – the space between the amount of goods and services the economy is actually producing and the amount it’s capable of producing when running full-out – actually opened up a bit in the past quarter. That implies an economy with a little bit of slack on its hands, which generally means it has more room to grow before we have to seriously start worrying about overheating and inflation – the two things the Bank of Canada generally worries most about.
The main reason the output gap widened, the Bank of Canada said, was because businesses have been investing more than previously believed in expanding their capacity. As a result, the Bank of Canada has upgraded its estimate for the country’s potential output growth. That means the economy should be able to grow a little faster and further without sending inflation skyward – which reduces pressure for any immediate rate hikes to tap the brakes.
The central bank still believes that the economy will generally grow a bit faster than potential output, which is why it is pretty adamant that it will continue to raise rates. But the biggest fly in the ointment is where business investment is headed.
Two key issues surrounding Canada’s competitiveness as an investment destination – the North American free-trade negotiations and the U.S. corporate tax cuts – have seriously clouded major spending decisions in corporate Canada. As the central bank’s thinking surrounding these risks has evolved, it has zeroed in on the implications for holding back spending on new capacity for exports, which have struggled in recent months. It estimated that the two factors could reduce business investment by 3 per cent by the end of 2020. It also estimated that the two elements could restrain exports by 1.4 per cent over the same time.
Mr. Poloz said this “investment/export nexus,” as he called it, is at the heart of the interest-rate question for the Bank of Canada.
“[Businesses] are hesitant to invest as much as they otherwise would. What that does is it prevents the economy from adding as much capacity as we would hope. It also prevents exports from growing as fast as we expected,” he said.
Any resolution of these issues, while certainly a good thing, would be a double-edged sword from a rate-policy perspective. If we saw some clarity in the next few months on NAFTA, and/or some policy response from the Canadian government to the U.S. tax cuts, it would open the door for businesses to accelerate their spending on new capacity. That would increase Canada’s ability to cultivate its exports, which would probably mean more economic growth – and faster growth would typically suggest earlier/more rate increases. However, the expanded capacity would also mean the economy would have more room to grow without fuelling inflation – meaning less pressure to raise rates.
Ultimately, the tie-breaker will be how it all plays out in inflation.
“The net effect on the inflation outlook will be our guide,” Mr. Poloz said.
The path of inflation will speak volumes about how much strain there is on capacity, and whether businesses are opening their wallets to give the economy more room to grow. The central bank will spend the next few months assessing how the competing factors influencing investment and capacity growth are affecting inflation, and let that signal the appropriate course for rate hikes.
Importantly, Mr. Poloz took pains to remind everyone that the Bank of Canada’s 2-per-cent inflation target is the mid-point of the bank’s target band of 1 per cent to 3 per cent – and that inflation had resided below that mid-point for a very long time. The unspoken message was that the central bank could live with inflation above the mid-point for a while, too, without feeling compelled to raise interest rates sooner, or faster. The mere fact that the Bank of Canada now sees inflation nudging above 2 per cent for the next couple of years does not, on its face, imply that the bank will be more aggressive on rate.