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Business Commentary Businesses send the Bank of Canada a clear message on rates: Hold the line

If the Bank of Canada listens to what Canadian businesses are saying about their state of mind and their prospects, then interest-rate hikes could be on the shelf for a long time. The question is whether the central bank should believe what it’s hearing.

The Bank of Canada released its quarterly Business Outlook Survey (BOS) this week, showing that the country’s business sentiment has taken a pronounced downward turn. Two elements in particular stand out: The percentage of businesses reporting that their production capacity is being squeezed slumped to a 3½-year low; and the number saying they are suffering from labour shortages tumbled from a post-Great Recession high to a three-year low.

From a rate-policy perspective, those stark numbers send a crucial signal: The private sector looks markedly further away from full capacity than it did a quarter ago. That implies less inflationary pressure, less risk of overheating – and, thus, little need for further rate increases. The business outlook is telling the bank pretty clearly to hold the line on rates – at least for the rest of this year, if not longer.

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Under its current governor, Stephen Poloz, the Bank of Canada has placed considerable emphasis on what businesses tell it, in its surveys as well as in informal discussions. It would be a shock if the findings in the quarterly BOS aren’t featured prominently in next week’s Monetary Policy Report (MPR) – the bank’s detailed quarterly economic outlook, its most important document in delineating its position on interest rates.

But there’s a danger in giving too much weight to the latest BOS readings in adopting what is widely expected to be a more cautious tone in next week’s MPR. It was only a few months ago that the central bank upheld positive business sentiment as a beacon for a quick rebound in the economy – even as a slumping oil market, stumbling exports and tepid business investment were, in fact, grinding growth to a halt. In hindsight, it looks as though business sentiment was out of step with a shifting economic trend.

Now, the BOS seems to be playing catch-up with the economic reality – and may still be behind the curve, as recent indicators suggest the economy has already rebounded significantly from the worst of its slowdown.

Some economists argue that the BOS isn’t much of a leading economic indicator. An analysis last year by Canadian Imperial Bank of Commerce showed that the BOS Indicator – a composite of the survey’s various measures – has a decent correlation with economic growth in the same quarter in which the survey was taken, but no correlation with subsequent quarters. At best, it reflects current conditions.

Perhaps that at least supports a case for the Bank of Canada to exercise caution about its immediate growth estimates; if businesses weren’t convinced that the economy was bouncing back late in the first quarter (the survey was taken from mid-February to mid-March), then that lack of conviction alone could tone down growth in that period.

However, there are reasons to think that the latest sentiment readings overstate their pessimism.

On the tumbling labour-shortage readings, consider the wording of the actual question asked in the survey: “Does your firm face any shortages of labour that restrict your ability to meet demand?” Given that private-sector employment surged by 300,000 from August to February, even as the pace of growth cooled, the response of “we’re fine, thanks” really isn’t surprising. Businesses may be less worried about shortages precisely because they have already brought lots of people aboard to fill their near-term-future needs.

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Similarly, the capacity question on the survey is: “How would you rate the current ability of your firm to meet an unexpected rise in demand?” Manufacturing data for February, released this week, showed that the inventory-to-sales ratio is at a 10-year high – evidence that businesses stepped up production in anticipation of a rebound in economic growth in the coming months. Businesses with ample stockpiles aren’t likely to be worried about how they are going to fill new orders.

It all suggests a private sector that was overly optimistic in the fall, overproduced and overhired, and now feels the need for a pause – but not necessarily burrowing in for an economic slump.

Of course, the Bank of Canada doesn’t have to guess at this; its researchers interview respondents to gather more details about what’s going on behind their responses to the formal survey questions. The bank’s policy-makers will want to pay special attention to those details. We may have a business climate that is cooler than it was a few months ago – but not nearly as cold as the BOS seems to suggest.

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