Rate hike prospects dwindle as growth cools

Theglobeandmail.com
Oct. 23, 2017
By David Parkinson

If you're an economic policy junkie, you'll be in your element in Ottawa this week.

Within 24 hours on Tuesday and Wednesday, Canada's two most powerful economic decision-makers - federal Finance Minister Bill Morneau and Bank of Canada Governor Stephen Poloz - will release key updates of their Canadian economic outlooks, as well as issuing closely scrutinized statements on the direction of interest rates (Mr. Poloz) and government finances (Mr. Morneau). It will be a lot to digest for even the most voracious consumers of economic policy.

The Finance Department gets things started on Tuesday with the release of its annual fall economic statement. In recent years, these mid-fiscal-year updates on the annual budget balance and the state of the economy have often morphed into mini-budgets, complete with new policy announcements. But it's unclear what else Mr. Morneau might have up his sleeve, having rolled out the details of a small-business tax cut and other changes to private-corporation tax rules last week.

One thing experts expect to see in the update is a dramatically improved fiscal situation over last spring's budget. The government's budgeted $28.5-billion deficit for the current fiscal year (ending March 31) was based on an economic growth projection of 1.9 per cent for 2017. Growth in the first half of the year averaged more than double that pace and private-sector economists now project growth of about 3 per cent for the full year.

That implies a big jump in government revenues over what it budgeted - giving it the means to sharply lower the deficit.

"The government has scope to trim the projected deficit by $10-billion in the current fiscal year, and to lower cumulative deficits by nearly $50-billion over the [five-year] projection horizon," Royal Bank of Canada economist Josh Nye said in a report last week. "The big question is whether the government will choose to spend some, or all, of this fiscal dividend."

Observers will have little time to fully assess the economic statement before the Bank of Canada takes over centre stage on Wednesday, with an interest-rate announcement and quarterly Monetary Policy Report.

A few weeks ago, the rate decision looked like a big event, after the central bank had announced back-to-back rate increases in July and September, the latter catching many market participants by surprise. Many central-bank watchers initially took the move as a signal that the Bank of Canada was in a hurry to raise rates further, in the face of a booming Canadian economy that had consumed the country's excess productive capacity much sooner than the bank had anticipated.

But the bank has used several speeches in the past few weeks from senior officials, including Mr. Poloz, to tone down the rate-hike rhetoric, striking a distinct tone of caution. That, combined with several recent economic indicators suggesting that the economy has cooled somewhat, have made another rate increase this week look unlikely. Financial markets are pricing in a less-than-20-per-cent chance that the central bank will raise its benchmark rate on Wednesday, down from about 50 per cent a month ago.

Just last week, Mr. Poloz stressed that the Bank of Canada's rate decisions are in "intense data-dependent mode" – the bank's shorthand for saying that it is closely watching the flow of economic indicators to determine the timing of its next move. While few doubt that that next move will be another rate increase, the recent data suggest there is no urgency.

Real GDP showed no growth in July compared with June, and indicators for August haven't been much better: the numbers have shown declines in exports and retail sales.

Ultimately, the most important indicator for the Bank of Canada is inflation, as the bank uses a 2-per-cent inflation target as its formal policy guide. Last Friday, Statistics Canada reported that the inflation rate climbed for a third straight month, to 1.6 per cent - an encouraging trend, but still significantly short of the bank's target.

Much of the attention on Wednesday will focus on the quarterly Monetary Policy Report. The central bank will need to revise some of its economic estimates, which, like those of the federal government, significantly underestimated growth earlier this year.

But the key for policy watchers will be the bank's latest projections on when it expects the country's output gap to close - that is, when it expects the economy to be producing at its full capacity - and when it sees inflation stabilizing at the 2-per-cent target. The two are highly related; a lack of spare capacity is the primary fuel for broad-based inflation.

The Bank of Canada has been signalling that it believes the rapid economic growth this year has narrowed the output gap quicker than it had previously anticipated. And the recent pick-up in wage growth - it was 2.2 per cent year over year in September, the highest in 17 months - also suggests tightening capacity and growing inflation pressures. But at the same time, the strong economy has meant that some businesses have increased investment, which has added new capacity.

In its previous update in July, it predicted that the output gap would close "around the end of 2017" and inflation would reach 2 per cent by mid-2018. If the bank adjusts those dates earlier, it would imply that the next round of rate hikes are nearer on the horizon.