The latest announcement by the Bank of Canada to maintain the bank rate at 0.5 per cent should come as no surprise. The decision adds more credence to the view that Canada’s bank rate is on hold indefinitely, and that the Bank of Canada is essentially stuck in a neutral gear.

We use the term “neutral” to describe a situation where there is no justification for a bank rate hike, nor alternatively, is there any compelling support for lowering the bank rate. In practical terms the Bank is "out of the business" when it comes to adjusting the bank  rate in response to changing economic conditions. Moreover, Canada’s central bank is no longer a driving force in shaping expansionary policies in Canada (Chart 1).

Chart 1 Bank of  Canada, Bank Rate, 1985-2016

Why the Bank Cannot Raise Rates

There are a range of compelling reasons why the Bank cannot hike its policy rate, such as:

• The gap between actual economic performance and potential remains unusually wide; Canada continues to have unused capacity in both labor and physical capital; the Bank anticipates that this output gap will not be closed until 2018;

• Inflation and inflationary expectations are well-contained in Canada; significant excess industrial capacity insures that any improvement in Canadian economic growth will not lead to an acceleration in the inflation rate, which is comfortably within the Bank`s target range of 1-3 per cent;

• Raising interest rates will, in essence, curb consumer spending which is already weak, and would also tighten financial conditions for Canadian exporters who operate in a highly competitive environment, especially since international trade has slowed considerably;

• Raising rates would further harm business capital investment; the sector that remains the weakest link in the economy;

• Canada’s central bank also has concerns about household levels of debt which are far higher than American counterparts; an increase in financing costs could have a serious impact on consumption and residential construction;  

• A related constraint on raising  rates is the risk of further stoking Canada’s overheated housing market ;

• Federal and provincial governments are looking to increase investment in infrastructure; higher rates would add to the cost and may reduce the amount of investment initially undertaken.

Why the Bank Cannot Lower Rates

Many analysts, these writers included, also believe that the Canadian economy is extremely weak and that the bank rate should be reduced. However, the reasons for not doing so are as follows:

• The current bank rate of 0.50 per cent is tight in the sense that lowering it now would leave little room for the central bank to deal with recessionary conditions in the future;

• Canada’s commercial banks have been operating with very low net interest rate margins; Canadian banks would be at a disadvantage in attracting short-term deposits needed for expending longer term bank loans if rates were even lower;

• Lowering the bank rate will have little impact on Canadian long term rates. Canada`s 10 year bond yields work off a spread to the U.S. bond rate and that spread is greatly influenced by U.S. bond market conditions ( Chart 2); Canadian rates have comfortably lower than those in the United States and are most likely to continue so.

Chart 2 Canada- US. Yield Curves,

( December 12,2016)

• Business capital investment in Canada has been quite unresponsive to interest rates and credit availability. Given the current low borrowing rates; it is not likely that a further drop in those rates, say of 25bps, would spur new investment; finally

• The CDN dollar would also weaken even further from a drop in the bank rate; yet, irrespective of bank policy, the currency has depreciated by some 30 per cent since 2014 (on the collapse of oil prices) and may continue on its own accord, unaided by any changes in domestic monetary conditions. ( Chart 3).

Chart 3   1 US$ per .CDN Dollar, 2016

For all of the above reasons (both pro and con), there is no compelling rationale for the Bank of Canada to move on its bank rate. Nonetheless, some Canadian economists maintain that there is about a 50 per cent that the Bank may lower rates and they anticipate that this will drive the CDN dollar down and test the previous low 67 cents earlier this year. Both developments will be needed to spur a return to better economic growth.