Bank of Canada governor Stephen Poloz has always talked about monetary policy as being a risk-management exercise. That approach is going to be put to the test this year, as mounting risks have become the pivotal determinant of where the central bank takes interest rates.
On Wednesday, the Bank of Canada decided to hold its benchmark rate steady at 1.25 per cent, just seven weeks after it had raised the rate for the third time in six months. It's not a huge surprise that the bank would move to the sidelines; even as it raised rates in January, it was talking a fair deal about caution and uncertainties. But what does stand out is how the risk factors now dominate the bank's narrative.
In the statement that accompanied the rate decision, it was hard to miss the elevation of the alarm on the U.S. trade file. The Bank of Canada described the rising protectionist tide coming from the White House as "an important and growing" source of uncertainty for the Canadian and global economy.
In the characteristically cool and measured language of central bankers, such a statement is a pretty strong choice of words. Giving added weight to those words is the fact that they appear very near the top of the statement – reflecting just how serious the escalating U.S. trade threats have become for the central bank.
The rate-decision statement also reveals the central bank's uncertainty about how severely the new mortgage rules that took effect at the start of the year will slow the housing market, saying that "it will take some time" for it to "fully assess" the impact on a sector that has been a key driver of the Canadian economy. And it's still unsure how the three interest-rate increases that are already in place will hit the economy, although it's pretty sure the sting will be greater than usual, thanks to the country's record household debt levels, which have heightened consumer exposure to rate changes.
Those uncertainties add up to substantial risk to Canada's economic outlook – and the risk is heavily loaded to the downside. That's especially true on the trade front, the biggest wild card the Canadian economy has faced in years. The best case on the NAFTA negotiations and the threatened U.S. tariffs is that we are able to emerge with something approaching the status quo; pretty much any other scenario suggests a worsening of conditions for a Canadian economy that is highly dependent on trade.
The bank is now weighing these downside risks against an economic backdrop that has been deteriorating anyway. Yes, it still believes the economy is running near its full capacity, which normally would justify using higher interest rates to ease off the economic throttle (and is the reason the bank raised interest rates three times beginning last July). But growth has disappointed over the past several months; the tepid pace in the second half of last year – averaging just 1.6 per cent annualized growth in the third and fourth quarters – implies that the economy hasn't been growing any faster than potential output is growing, and thus capacity strains likely haven't gotten much tighter in recent months.
Meanwhile, a surge in business investment last year has added new capacity to the economy, making those pressures look even less pronounced. With the economy starting 2018 at a lower point than the Bank of Canada had believed a couple of months ago, and continuing to show sluggishness, there's already a danger that capacity won't be pushed this year to the same extent that the bank had previously anticipated.
And with economic growth no longer making an emphatic case for higher rates, the risks are taking over the conversation. That makes a strong case for lowering interest-rate expectations for this year. The likelihood for economic disappointment is climbing, and that's the nicest way of viewing it. If the trade situation culminates in the United States scrapping NAFTA entirely, you can throw the forecasts right out the window.
The financial markets have already started to back away from their rate expectations, but they still see two more quarter-percentage-point hikes before the end of the year. Given the uncertainties – and, importantly, the Bank of Canada's increased emphasis on them – that now looks optimistic.
In the absence of an unanticipated pick-up in the economic pace this year, the central bank has no good reason to resume rate hikes until it at least has some visibility into the key risk factors affecting its outlook. That kind of visibility is unlikely by July, which is when the bond market is still pricing in the timing of the next rate hike. The full impact of the mortgage changes probably won't be evident by then, and it takes at least 18 months for the full effects of the previous rate increases to work their way through the economy.
On the trade front, it could well emerge that the fog won't clear until after the U.S. congressional mid-term elections in November, which will go a long way to determining how much support President Donald Trump has in Congress to push his trade agenda. If you pick a date when the Bank of Canada will have enough visibility on the biggest risk factor standing in the way of further rate hikes, you might want to forget about July – and circle the December rate decision on your calendar.