The Bank of Canada pushed forward with its third quarter-point interest rate since July, while cautioning it’s in no rush to return borrowing costs to more normal levels as uncertainty around Nafta talks cloud the outlook.
Policy makers led by Governor Stephen Poloz increased the benchmark overnight rate to 1.25 percent, bringing it to the highest since the global recession. The move is a nod to a red-hot economy running up against capacity with a jobless rate at the lowest in more than four decades.
At the same time, central bank officials repeated their dovish language about moving ahead cautiously and warned they expect the economy will require continued stimulus to remain at capacity. The Canadian dollar and bond yields slipped while stocks rallied.
“While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target,” the Bank of Canada said Wednesday in a statement from Ottawa. “Governing Council will remain cautious in considering future policy adjustments.”
Canada becomes the first major central bank to move ahead with a rate increase in 2018. Investors have spent the early days of the year watching central banks around the world for signs the period of extraordinary stimulus is coming to an end. The Bank of Japan jolted bond markets with a surprise change to its purchasing program, while some European Central Bank officials have called for their bond-buying program to end in September.
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For months, Poloz has been trying to strike a balance between gradually bringing interest rates back to more normal levels amid faster-than-expected growth and an employment boom, without triggering a slowdown.
A recent run of strong economic data has made that task more difficult, and the improved outlook was evident throughout Wednesday’s rate statement and monetary policy report.
The central bank painted a picture of an economy with inflation already close to target, output largely at capacity, a stronger- than-expected housing sector, and a faster-than-expected reduction in labor market slack. That prompted officials to increase their projections for inflation in 2018, and growth over the next two years.
The reasons to remain cautious are less tangible, centered around growing concerns about the outcome of Nafta talks, which resume next week in Montreal.
“Uncertainty surrounding the future of the North American Free Trade Agreement is clouding the economic outlook,” the central bank said.
There are also questions about the economy’s sensitivity to interest rate increases and whether its potential growth could be accelerating. The bank said wage gains remain modest, even with a recent pickup.
The Bank of Canada forecast a bigger hit on exports and business investment due to worries about Nafta, and incorporated an increased sensitivity of interest rates because of the country’s high household debt levels.
The central bank is taking a warranted “wait and see” approach on the impact of Nafta and U.S. tax reform, Steve Ambler, the David Dodge Chair in Monetary Policy at Canada’s C.D. Howe Institute, said by phone. The combined effect is “going to make firms look long and hard before they sink money into the Canadian economy rather than the American economy.”
The rate increase was expected by 26 of 27 economists surveyed by Bloomberg and investors had almost fully priced in a hike.
Questions remain about how quickly the central bank will raise from here and where rates will eventually settle. Markets had been pricing in at least three increases this year, which would bring the benchmark rate to 1.75 percent. Odds were largely unchanged following the statement.
The Canadian dollar fell 0.4 percent to C$1.2486 per U.S. dollar at 10:41 a.m. in Toronto trading. Two-year Canadian government bond yields fell 2 basis points to 1.75 percent.
“We share the Bank of Canada’s view that higher rates will be needed over time. But perhaps not as fast and furious as the market was starting to think,” Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, said in a note to investors.
The Bank of Canada retained its estimate that its so-called neutral rate — a sort of Goldilocks rate that keeps the economy neither too hot nor too cold — at about 3 percent. But the comments on the need for continued accommodation at full capacity could suggest policy makers aren’t anticipating a return to neutral any time soon.
The central bank also increased its forecast for how quickly the economy could grow without triggering inflation — to an average of 1.6 percent over the projection horizon. The central bank said it is monitoring the extent to which strong demand could boost potential growth further.
“In this respect, capital investment, firm creation, labor force participation, and hours worked are all showing promising signs,” it said, adding that wages have picked up by less than what “would be typical” for a labor market without slack.
— With assistance by Greg Quinn, Erik Hertzberg, Luke Kawa, and Josh Wingrove