Bank of Canada Finally Finds Cause for a Hike

July 12, 2017

There was no surprise among market participants in today’s decision by the Bank of Canada to raise its overnight rate target a quarter point to 0.75%. This move had been fairly well communicated over the last few weeks in official remarks, but communication as to when the Bank might lift rates again was lacking. This is different than our experience with the Federal Reserve, where the initial move in December was predicated on a trajectory of at least two more increases in 2017 and then further in 2018. As I commented in the last newsletter, the Bank has been reluctant to follow the Fed given the persistent below-target inflation performance and continued risks facing exports.

Today, the rationale put forward for the move was that Canada’s output gap would close by the end of this year rather than the first half of 2018 (which was the Bank’s projection in April). It also believes that risks are balanced and that inflation will return to target. If the output gap is in fact months away from disappearing one would have thought that the Bank would signal a path of further hikes (the next meeting is September). Instead, it kept to its mantra of watching economic indicators. Most analysts believe Mr. Poloz will refrain from raising rates in September and defer to October. Even still, this would simply remove the emergency rate cuts enacted in 2015.

One thing arguing against a rapid succession of hikes is that the Canadian dollar is quickly becoming less competitive again. Today’s announcement has sent the Loonie above 78.50 US cents and is close to retesting the high near 79 cents set in June 2016. In May of last year it broke briefly above 80 cents. Given the moderation in US growth I believe this will cause the Bank to maintain a cautious stance. Therefore, any further gains in the Loonie will likely be viewed as being short-lived and the knee-jerk lift in Canadian bond yields will also likely find a ceiling.