While the Bank of Canada’s decision to hold the key interest rate steady was expected, the Governor revealed a lot of concern about why he is very cautious about the longer-term outlook. Granted, he spoke about the current weakness in several sectors as being temporary and a return to a more favorable growth path in 2020. But here is a central banker that wishes rates were higher, yet he is facing a wave a downside pressures that dull his conviction that rates have to go up. It is very difficult to ignore the forces that are holding back economic growth.
Along with the rate announcement, the Bank released its Monetary Policy Report[1] which focuses on those “risks identified as the most important to the projected path for inflation, drawing from a larger set of risks considered in the projection”. For bond investors, this analysis of risks speaks volumes of why the Bank finds itself in such a quandary and why the Governing Council settled for keeping rates unchanged. Reviewing these risks, the Bank acknowledges that:
- Global trade relations are still in a nervous state of flux. The fact that the Canada-United States Mexico Agreement (CUSMA) has yet to be ratified prolongs uncertainty. Moreover, there is absolutely no movement on the part of the US Congress to ratify the treaty, and it is entirely possible that it will not get done prior to the next presidential elections. Tariffs continue to plague the cross-border trade in steel and aluminum while the treaty remains unsigned. The report goes on to state that “If tensions persist or escalate, Canadian exports and business investment could suffer from additional weakening in foreign demand, a disruption in global value chains, falling business confidence and lower commodity prices”. This is not a positive prospect.
- Financial conditions are tightening globally. Strangely, the Bank argues that this could lead to higher interest rates and greater pressure on debt servicing. However, a completely different interpretation leads to quite a different outcome. As money supply growth slows and business and consumers find it more difficult to borrow, we can anticipate a worsening financial condition. In Canada, for example, the banks have retrenched to some extent, especially on mortgage lending, and this is now hitting the housing sector.
- Global demand is weakening. This could result in a decrease in commodity prices. Canada, relying heavily on commodity exports, would experience further sluggishness in business investment and exports.
- Residential investment is slowing. The Bank introduced several policy changes affecting mortgage lending and is watching that these tougher rules do not result in residential investment slumping further and spilling over into the economy in general.
The Governor has not given up entirely on the need for rate hikes, he just has put that policy approach off to the sidelines. Very revealingly, he refers to their decision to lower the neutral rate of interest--that is, the rate which is consistent with full employment without exceeding the inflation target. The neutral rate now has dropped by 25pbs into the range of 2 ¼-3 ¼ percent. The economy clearly is not able to grow as fast as was previously thought. This is another reason to argue for a very long pause on further rate hikes.
[1] Bank of Canada, Monetary Policy Report, April 2019
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