Steve Ambler is the David Dodge Scholar in monetary policy at the C.D. Howe Institute, and professor of economics at the school of management, University of Quebec at Montreal. Jeremy Kronick is senior policy analyst at the C.D. Howe Institute.
As was widely expected, the Bank of Canada announced on Wednesday that it was not changing its target overnight rate. Despite the announcement reinforcing expectations, the emphasis on caution was enough to knock more than a half a cent off the value of the Canadian dollar before the end of Wednesday morning. With uncertainty on the horizon for 2018, the year promises to be a challenging one for our central bankers – one that will require market guidance.
The overall tone was balanced and the announcement emphasized caution. The global economy is in good shape with U.S. growth in the third quarter stronger than expected. Risks, however, remain in the form of geopolitics and trade. It also simultaneously warned that "higher rates will likely be required over time" while indicating that "Governing Council will continue to be cautious, guided by incoming data, in assessing the economy's sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation."
However, there were two interesting omissions as we look out into 2018, which are themselves quite predictable but whose effects are harder to ascertain. The first is an impending series of interest-rate hikes by the U.S. Federal Reserve, and the second is the regulatory changes that will impact Canadian housing markets as the calendar turns over.
According to a Reuters poll, the Fed is almost certain to hike rates later this month, and a majority of the economists polled expect three more rate hikes in 2018. Hikes by the Fed will lead to further depreciation of the Canadian dollar unless they are matched by increases in the Bank of Canada's overnight rate. This will help to boost exports and overall demand while putting upward pressure on inflation.
On the domestic front, OSFI's B-20 guidelines for the underwriting of residential mortgages are due to take effect on Jan. 1. They will certainly have the effect of cooling housing demand and reducing prices while putting a brake on additional household indebtedness.
While the qualitative effects of these changes are clear, the quantitative effects are largely uncertain – and may actually pull inflation and economic activity in opposite directions. Fed rate hikes may put upward pressure on inflation, while the new mortgage rules will slow housing demand and, therefore, prices. Additionally, if the bank judges that an increase in the overnight rate is warranted as a result of upward pressures in inflation from Fed rate hikes, this might exacerbate Canada's housing indebtedness situation despite the new OSFI guidelines.
What is certain is that the Bank of Canada has spent considerable time and effort simulating the effects of different scenarios as well as the effects of its own possible reactions to these changes.
It will have surely estimated the relative impact of U.S. interest-rate hikes on demand and inflation, and how much of an interest-rate differential it is ready to tolerate before deciding to dampen these effects with hikes of its own.
Similarly, it will have simulated alternative scenarios of the impact of OSFI's regulatory changes on households' borrowing and spending decisions. A stronger predicted impact of the regulatory changes will take pressure off the bank to hike rates in response to financial stability concerns.
By communicating its thinking on these complicated issues to the public, the bank could enhance the predictability of the future path of the overnight rate. In turn, this could only enhance the effectiveness of its monetary policy, which depends on the ability of changes in its policy rate to affect demand and prices. The current value of the overnight rate only has a strong effect on short-term interest rates. It is medium-term financial conditions that affect household and firm decisions to spend, and these are largely dependent on the path of the overnight rate.
There is now a considerable divergence of opinion among forecasters concerning that path. The major banks are forecasting an overnight rate at the end of 2018 of between 150 basis points (CIBC, Scotiabank and TD) and 200 basis points (National Bank). To us, this wide divergence in views means that the bank could be doing a better job of conditioning expectations.
With 2018 likely to bring considerable uncertainty, opening up to the public may bring a little new year's cheer.