The Bank of Canada approaches one of its most difficult interest-rate decisions in years Wednesday, as financial markets and experts remain split on whether the economy needs a kick-start from lower interest rates.
Governor Stephen Poloz and his colleagues will release their latest rate announcement at 10 a.m. (ET), unveiling whether they will leave the key policy rate unchanged at its current 0.75 per cent, or cut it to 0.5 per cent in the face of an economy that slipped perilously close to a recession in the first half of the year.
Unlike in January, when almost no one had expected the quarter-point rate cut that the central bank sprung on markets, central bank watchers are braced for a possible rate cut – but they are far from agreement. Bond-market prices indicate that traders put the odds of a rate cut Wednesday at about 40 per cent. Think-tank C.D. Howe Institute’s Monetary Policy Council, made up of some of the country’s top monetary economists, has recommended that the central bank leave its key rate unchanged, but more than one-third of the council members called for a cut.
These are some of the key factors Mr. Poloz and his colleagues have been weighing in their deliberations leading up to Wednesday’s decision:
Three good reasons for a rate cut
1. Growth – or lack thereof
Canada’s gross domestic product shrank at an annualized rate of 0.6 per cent in the first quarter of the year, dragged down by the impact of the oil shock, a harsh winter and a slowdown in the economy of the United States, our biggest trading partner. The central bank was confident that Canadian growth would rebound in the second quarter, but economic data suggest the economy may have instead slowed further. Canada’s non-energy exports – which were supposed to lead the way in the anticipated growth recovery – fell again in May (the latest available data), their fourth drop in five months.
While there’s still a chance that the anticipated rebound is just a little late in arriving, the Bank of Canada will be feeling pressure to stimulate an economy that has struggled for a half a year now. And one immediate effect of a rate cut would be downward pressure on the Canadian dollar – which would help the country’s exporters.
2. The oil shock, and its aftershocks
Even if the biggest damage from the plunge in oil prices was already absorbed in the first half of the year, the lingering drag on the country’s economy is far from over. Capital spending in the oil and gas industry is expected to plunge 40 per cent this year. Excluding residential construction, first-quarter business fixed capital formation – the key measure of how much businesses are spending on facilities, equipment and machinery – fell at an annualized rate of more than 17 per cent from the fourth quarter, and was the key contributor to the GDP decline. And after oil prices managed to rally over the spring, they have started to slide again – down nearly $10 (U.S.) a barrel in the past month.
3. The Monetary Policy Report
The Bank of Canada sets interest rates eight times a year, but only four of those setting dates – in January, April, July and October – also include its Monetary Policy Report, in which it provides a detailed explanation of its position on rates and updates its outlook on the economy. Mr. Poloz also holds a press conference in conjunction with the report. While there is nothing stopping the central bank from making major changes to policy on the setting dates that don’t include a report and press conference, those report dates give it a much better opportunity to fully explain the reasons behind its decision. If Mr. Poloz doesn’t cut now, it will be another three months before he has as good a chance to explain himself.
Three good reasons to hold steady
While GDP reports paint a picture of an economy on the verge of a recession, employment reports tell a different story. Canada’s labour market added nearly 100,000 net new jobs in the first six months of the year, including nearly 140,000 full-time jobs. That helped household income grow at its fastest pace in seven years in the second quarter. This relatively healthy employment picture suggests the growth sluggishness in the first half may be a temporary blip.
2. A U.S. bounce-back
The U.S. economy also slumped in the first quarter, amid a nasty winter and strikes at key West Coast ports. But a wide range of economic indicators suggests that the U.S. has bounced back smartly from these temporary factors. Economists peg second-quarter GDP growth at about 2.5 per cent annualized, and expect a pace of about 3 per cent in the second half of the year. The U.S. rebound implies that a resurgence in Canadian exports, which Mr. Poloz has long held as a key to Canada’s recovery, is right around the corner.
3. The household debt burden
Canadians’ ratio of household debt to disposable income remains close to record highs, due primarily to a build-up in mortgage debt. Years of low interest rates have made borrowing cheap, keeping demand for housing high and elevating home prices. Many critics argue that further rate cuts would only pour gasoline on an already intense debt fire, increasing the risk to the country’s economic and financial-sector stability. The Bank of Canada is keenly aware of this risk; while it doesn’t consider the threat sufficient to prevent it from cutting rates, it certainly would weigh in the debate.