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Posted Thursday January 10, 2019


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Expectations

On hold, with Governing Council seeing policy rate rising to neutral "over time"

As expected, the Bank of Canada left the policy rate at 1.75%; The Governing Council still sees a need for the policy rate to rise to neutral (between 2.5% and 3.5%), with the added proviso "over time"; The BoC said that the pace of rate hikes will depend on developments in oil and housing markets, and global trade policy - by David Watt

The Bank of Canada left its policy rate unchanged at 1.75%. This was in line with consensus expectations. As well, the market was fully priced for no change.

The Bank of Canada maintained a bias to tighten. The Governing Council still judges that the policy rate will need to rise toward neutral, though the proviso "over time" was added to the policy statement. In assessing the pace of rate hikes the Bank will pay attention to developments in the oil market, the Canadian housing market, and global trade policy.

The BoC estimates that the neutral rate is between 2.5% and 3.5%. The Monetary Policy Report (MPR) said that the Bank's economic forecasts for 2019 and 2020 were based on the mid-point of the neutral range (3.0%). This is the same policy rate projection that was used in the October MPR.

Reflecting the drop in oil prices in late 2018, and the Province of Alberta's mandated reduction in oil production in early 2019, the Bank of Canada lowered its 2019 GDP growth forecast to 1.7% from the prior 2.1%. Weaker than expected consumption and housing investment were noted as other factors behind the reduced 2019 GDP growth forecast.

However, the Bank anticipates exports and non-energy investment will grow solidly, supported by foreign demand, a weaker Canadian dollar, federal tax measures targeted at investment, and the CUSMA (the Canada, US, Mexico Agreement that will replace NAFTA). With demand anticipated to see renewed momentum following a temporary slowdown in 2018 Q4 and 2019 Q1, the Bank anticipates, GDP growth to rise to 2.1% in 2020. This is up from 1.9% in the October Monetary Policy Report.

The BoC's global GDP growth forecasts were unchanged at 3.4% for 2019 and 2020. Similarly, the US economy is still projected to grow by 2.4% in 2019 and 1.6% in 2020. Rising US business investment is projected to be an important driver of Canadian machinery and equipment exports.

That said, the Bank also noted that there are "increasing signs" that the US-China trade conflict is weighing on global demand and commodity prices.

In the press conference Bank of Canada Governor Stephen Poloz said that the Bank remains "decidedly data dependent." Governor Poloz also said that the Governing Council believes that the economy is on "solid footing," despite the challenges currently affecting oil producing regions.

Implications

We project GDP growth of 1.6% in 2019 and 1.8% in 2020. Thus, our forecasts are for slightly slower GDP growth this year and next. Our forecasts are also based on a lower profile for the policy rate.

In our view, the key differences between our economic outlook and that of the BoC, is our assessment that the Bank of Canada is placing too much faith in exports and non-energy investment, and is overly optimistic that the household sector can digest the policy rate rising toward 3.0%. First, we will await evidence that free trade agreements with EU, the newly in force CPTPP, and CUSMA, are providing lift to non-energy exports given that non-energy exports, in real terms, have been flat for four years. Second, we see the household sector as more vulnerable to interest rate increases, with rising debt service costs likely to restrain consumption spending.

While the Bank's policy statement clearly indicates that rates are set to rise, it also suggests that there is little urgency to raise rates quickly. To us, the lack of urgency is predicated, in part, on the downward pressure on inflation from lower gasoline prices that will leave inflation below 2% through most of 2019. As well, downward pressure on economic activity in the oil producing regions, and revisions to the National Accounts that lowered the level of GDP in prior years suggest that there will be a greater amount of slack in the economy than the Bank had projected in October. As a result, we assess this statement to represent a less hawkish stance than in October.

However, the Bank of Canada was not dovish. Instead, the BoC maintains a solidly positive outlook for exports and non-energy investment. In the press conference, Governor Poloz said that the Governing Council believes that the economy is on "solid footing," despite the challenges currently affecting oil producing regions. As well, inflation is expected to rise back toward 2% by the end of 2019 based in part on the unwinding of temporary downward pressures, above potential GDP growth, and pass through effects from a weaker Canadian dollar. In the MPR, the Bank projected the Canadian dollar at 74 US cents, down from the 77 US cents used in October. Finally, the Bank, as in October, based its economic forecasts for 2019 and 2020 on a projected policy rate of 3.0%.

We expect the Bank to raise the policy rate to 2.25%, up from 1.75% currently, with 25 basis point increases anticipated at the 6 March and 29 May meetings. Thus, while we do anticipate a rate hike at the next policy meeting, we expect the policy rate to remain below the lower bound of the Bank's neutral range, and well below the 3.0% level used in the Bank's forecasts.

David Watt is Chief Economist, of HSBC Canada











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