Bank of Canada set to hold interest rates

The Bank of Canada is expected to hold borrowing costs steady Wednesday in what will probably be just a pause on its hiking path.

After four increases since mid-2017, including at their last meeting in July, investors and economists anticipate policy makers will take a breather this week and leave the benchmark overnight interest rate at 1.5 per cent, before raising again as early as October.

After a prolonged period of sluggish growth, the economy is finally doing well enough that it no longer needs abnormally low interest rates — even in the face of all the uncertainty around trade. Governor Stephen Poloz’s job is to wean Canada off of easy money in a way that doesn’t inadvertently damage the expansion and to do that, he needs to decide on two things: How high do interest rates need to go, and how quickly should policy makers raise borrowing costs to get there?

HIKE PACE

As many as three more increases are priced in over the next year. In all, the market is expecting a string of hikes that will bring official borrowing rates back up to 2 per cent for the first time in a decade. Canada has the second highest central bank rate in the Group of Seven after the U.S.

This is considered a gradual path for rate hikes. The central bank’s models are already telling policy makers they’re behind the curve on normalizing borrowing costs but last week’s developments on the North American Free Trade Agreement highlight why Poloz will avoid rushing. Canada is still on the outside looking in on a NAFTA deal, has already been hit by U.S. metals tariffs and is facing Donald Trump’s repeated threats of auto tariffs. None of this will be resolved by Wednesday and may be enough in itself to keep policy makers on hold.

With the possibility of a trade shock to the economy still real, the Bank of Canada is wary of the consequences of having to reverse policy in midstream. And trade is just one of a long list of uncertainties — the list includes questions over whether the economy truly is at capacity — that has kept the central bank spreading out rate hikes.

Another major unknown for policy makers is how high rates should go. The central bank’s economists estimate the economy’s “neutral” rate — a level that is neither stimulative or contractionary — is somewhere around 3 per cent, but Poloz has been explicit that there is plenty of uncertainty around that figure.

It’s possible that given high debt levels and other factors, such as the inability of the nation’s businesses to capitalize on strong global demand, the economy can’t really cope with an official rate of interest much above 2 per cent. Lending rates offered by commercial banks to their best customers are typically another 2 percentage higher than the overnight rate.

Which is why markets are anticipating Poloz won’t raise his benchmark rate much beyond 2 per cent by next year, and that he’ll leave it there indefinitely until the question of what is “normal” can be answered with more certainty.

While normal remains a puzzle, there is more certainty about what is abnormal. For Poloz, it’s a situation where the policy rate is below the central bank’s 2 per cent inflation target. And, he has claimed, there is nothing in the economy now that would justify rates below that level.

Canada is experiencing broad-based growth and absorbing much of the remaining slack in the economy. Evidence of tightening is mounting: the unemployment rate is hovering at four-decade lows, workers are getting bigger pay raises, and companies are reporting record job vacancies. Inflation is at a G7 leading 3 per cent.

Which is why the central bank’s hiking path still has at least a bit to go.

–With assistance from Erik Hertzberg.

Bloomberg.com

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