The Bank of Canada took a significant step toward unwinding its emergency stimulus on Wednesday, becoming the first major central bank to adjust its monetary policy in light of the vaccination rollout and mounting evidence that the economy is weathering the pandemic better than expected.
The central bank said it will reduce its pace of Government of Canada bond purchases, known as quantitative easing, to $3-billion a week from $4-billion. The bank kept its overnight policy rate at 0.25 per cent, but shifted its forward guidance for a potential rate hike to the second half of 2022 from 2023.
This puts the Bank of Canada ahead of the U.S. Federal Reserve, and other central banks, in unwinding the massive amount of monetary stimulus announced in the early months of the pandemic. It comes alongside a dramatic adjustment to the bank’s economic outlook for the Canadian economy.
The bank now expects the Canadian economy to grow 6.5 per cent this year, up from 4 per cent that it forecast in January, and notably higher than the 5.8-per-cent GDP growth projection the federal government used in its budget on Monday.
This revision is driven in large part by stronger-than-expected growth in the first quarter of 2021. GDP is expected to have grown by around 7 per cent in the first three months of the year despite a second wave of COVID-19 infections and heightened lockdown measures. That’s a stunning contrast to the bank’s January forecast, when it predicted GDP would shrink by 2.5 per cent in the quarter.
“Lockdowns through the second wave had much less economic impact than they did through the first wave. And as restrictions were eased, the economy bounced back quickly with substantial job gains in February and March,” Bank of Canada Governor Tiff Macklem said at a Wednesday morning press conference.
He added, however, that the latest rise in coronavirus infections and renewed physical-distancing measures will likely result in some of the job gains being reversed.
“One can quibble that they likely should have adjusted their narrative more quickly as vaccine trials were reported and fiscal stimulus plans took off in the U.S. and Canada alongside evidence of a more resilient economy than they feared,” Derek Holt, head of capital markets economics at Bank of Nova Scotia, wrote in a note.
“Nevertheless, they are courageous enough to now stand apart from the pack of most global central banks.”
The announcement of a $1-billion reduction in the pace of quantitative easing was widely expected. The bank has been buying government bonds in an attempt to hold down benchmark interest rates, making borrowing cheaper across the economy.
After buying billions of dollars worth of government bonds every week for the past year, the bank now owns 42 per cent of the federal government bond supply. Economists have been saying for months that the bank needed to “taper” its pace of buying so it did not cause problems in the bond market.
Mr. Macklem said Wednesday’s taper is the result of an improving economy, not technical concerns about market functioning. Any further adjustments to the QE program, he said, “will reflect our assessment of the strength of the recovery and its durability.”
The more significant change is around the central bank’s forward guidance for a rate hike. Since last summer, the bank has said that it will keep its overnight policy rate at the “effective lower bound” of 0.25 per cent until slack in the economy is absorbed and inflation is sustainably hitting 2 per cent. It is now expecting these two conditions to be met by the second half of 2022, instead of 2023.
This change “opens up a notable gap with a still-cautious Federal Reserve that is claiming that it can wait until 2024 for U.S. rate hikes,” Avery Shenfeld, chief economist at CIBC World Markets, wrote in a note.
“For our part, we see the Bank of Canada hiking in the final quarter of next year, but the Federal Reserve dropping its own pessimism even more dramatically, and hiking by Q3 of that year,” Mr. Shenfeld wrote.
The revised guidance does not guarantee a rate hike in 2022. There is “nothing mechanical” about a rate decision, Mr. Macklem said, adding that there is an “unusual amount of uncertainty” in the bank’s forecast.
“We know there’s going to be some destruction of [economic] capacity from this crisis, particularly in the hardest-hit sectors. But at the same time, we’re seeing accelerated investments in digital technologies, and that will be adding to capacity,” he said.
In its quarterly Monetary Policy Report (MPR), published Wednesday, the bank revised its forecast for potential output growth upward, having slashed it in October.
It now expects potential output for the Canadian economy to grow by about 1.6 per cent on average over the next three years. This reflects less scarring to the labour force than expected – that is, permanent or semi-permanent damage caused by joblessness – as well as stronger expected business investment in things such as automation and digitalization. Even with the improvement, the bank expects potential output to still be about 1 per cent below prepandemic levels by 2023.
On inflation, the bank expects growth in the consumer price index to come close to 3 per cent in the coming months, largely as a result of year-over-year price comparisons for gasoline. The MPR projects 2.3-per-cent inflation in 2021, 1.9 per cent in 2022 and 2.3 per cent in 2023.
Statistics Canada released its monthly inflation data Wednesday, showing CPI rose 2.2 per cent in March on a year-over-year basis.
Mr. Macklem indicated that the bank will let inflation run slightly above target as the recovery picks up pace. This is the result of the bank’s decision to provide forward guidance for rate hikes, he said.
“The biggest risk was deflation; inflation being too low. We took out some insurance [by giving forward guidance] to get it back to target quickly. And the consequence of that is the forecast has a small overshoot,” he said.
Wednesday’s announcement had little to say about cooling Canada’s red-hot housing market. Mr. Macklem reiterated that the bank is watching for signs of excessive exuberance, and commended the Office of the Superintendent of Financial Institutions for its recent proposal to introduce stricter mortgage stress tests.
However, he maintained that interest-rate hikes are too blunt a tool to deal with froth in the housing market.
“Monetary policy is a broad macro instrument, and we really need to look at the needs of the whole economy,” he said.
“There are still at least 500,000 Canadians who are out of work, relative to the employment rate before the pandemic, and there’s considerable excess supply in the economy. Right now the economy needs our support,” he said.
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