Positive signs from a key Canadian economic indicator and an upbeat statement from the U.S. central bank injected a double-dose of optimism about the strength of the North American economy Wednesday – feeding expectations that further interest-rate increases are coming by spring, on both sides of the border.
Statistics Canada reported that November real gross domestic product grew 0.4 per cent month over month, the biggest one-month increase since May. It was an impressive rebound from October's flat reading and partly reflected a strong recovery in the country's manufacturing sector, after the return of two major auto plants from October shutdowns.
Economists had largely expected the November bounce-back, in light of previously released monthly data that showed a recovery in manufacturing and exports. But they noted that the growth spurt went well beyond the country's factories, as 17 of 20 industry sectors recorded gains.
After a relatively tepid third quarter and October's weak start to the fourth quarter, the November figures are an encouraging sign that Canada's broad-based economic recovery is on track.
"The Canadian economy fired on all cylinders in November: Production resumptions led the way, but nearly all major sectors reported gains on the month," Toronto-Dominion Bank senior economist Brian DePratto said in a research note. "As shown by this month's breadth of growth, the underlying trend for the Canadian economy remains a positive one."
Meanwhile, the U.S. Federal Reserve decided to leave its key interest rate unchanged in its first rate-setting meeting of the new year. But the brief statement accompanying the decision suggested the Fed is prepared to raise rates again at its next meeting, in March, in light of further strength in key U.S. economic indicators – and, most significantly, what it now sees as rising inflationary pressures.
The statement upgraded the Fed's assessment of growth in household spending and business investment, now identifying them along with the U.S. job market as "solid" sources of economic growth. It said market-based indicators of inflation expectations are rising. Crucially, it said it now anticipates rising inflation "this year" – replacing its previous bleak assertion that it expected inflation to remain below its 2-per-cent objective "in the near term" – considered a significant upgrade in the inflation outlook.
The statement removed whatever doubt remained in financial markets that another quarter-percentage-point Fed rate increase is coming at the March meeting, adding to the Fed's three quarter-point rate hikes last year. The Fed's key rate, the federal funds rate, is now set at a range of 1.25 per cent to 1.5 per cent, after the most recent hike in December.
As of Wednesday afternoon, the bond market put the odds of a March Fed rate hike at 99 per cent, up from 90 per cent the day before the Fed statement.
In Canada, meanwhile, the encouraging GDP rebound added modestly to the chances that the Bank of Canada will follow the Fed's lead and hike its own key rate again in the spring, although the hike is still considered less certain in Canada's case. On Wednesday afternoon, the bond market was pricing in a 60-per-cent chance of a quarter-point increase in the Bank of Canada's April rate decision, up from 57 per cent a day earlier.
The Canadian central bank has already raised rates three times since last July, lifting its key rate to 1.25 per cent from 0.5 per cent in the process, as the Canadian economy's rapid growth in the first half of 2017 has left the economy with little or no excess capacity – raising inflationary pressures and justifying raising rates from their historically low and highly stimulative levels.
Most economists believe the Bank of Canada still has at least two rate increases up its sleeve this year. The solid November GDP report added some confidence to those expectations, as the pace of growth, while relatively moderate, still implies that the economy is eating up whatever spare capacity it has left.
But many economists, including those at the Bank of Canada, are concerned that those rate increases themselves pose a big risk to the pace of economic growth this year – chiefly because of the record levels of debt being carried by Canadian households. In its quarterly Monetary Policy Report in mid-January, the Bank of Canada warned that "elevated levels of household debt are likely to amplify the impact of higher interest rates on consumption." It said this concern is a key reason why it plans to be "cautious" in its pace of further interest-rate increases.