Canada’s rate rise is latest shift in global central bank policy

Canada has raised interest rates for the first time in nearly seven years, joining the US Federal Reserve in leading a monetary policy shift across major industrialised countries in response to better global economic growth.

The Bank of Canada lifted rates by 25 basis points to 0.75 per cent on Wednesday, saying recent data had “bolstered the Bank’s confidence in its outlook for above-potential growth and the absorption of excess capacity in the economy”.

BoC governor Stephen Poloz and his deputy Carolyn Wilkins had primed the market for the first rate rise since December 2010 with hawkish speeches last month, followed up by further bullish comments about the Canadian economy at the gathering of central bank policymakers in Sintra two weeks ago, and in an interview last week.

Analysts suspect three reasons underpin the BoC rates move. First, policymakers are keen to positioning monetary policy to tackle the prospect of rising consumer prices.

Core inflation is running at 1.3 per cent year-on-year and is below its 2 per cent target and trending lower. But the BoC says that it expects inflation to come close to its target in mid-2018. The BoC noted that further rate moves “will be guided by incoming data as they inform the Bank’s inflation outlook”.

Second, they want to drive rates higher to lessen the likelihood of financial instability — lower rates encourage investors to take risks. Persistently low rates has contributed to an overheating Canadian property market, forcing the government to work with provinces to try to cool prices with regulations and taxes.

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“Stephen Poloz feels complicit in the froth in some housing markets in Canada,” says Stephen Gallo, a forex strategist at Bank of Montreal.

Third, the BoC wants to get closer to Fed monetary policy to prevent fluctuations in the Canadian dollar’s value against its US counterpart.

As the dust settled from the rate decision, the Canadian dollar rose 0.7 per cent against the US dollar to C$1.2824, its strongest level since August 2016. Canada’s equity market trimmed a gain of 1 per cent after the rates decision.

The Federal Reserve has been out on its own in normalising rates, with four hikes since December 2015, but after years of monetary easing among other G10 countries, investors now believe several of them are ready to follow suit.

In the run-up to this week’s meeting, the BoC was encouraged by strong GDP data. The labour market is strengthening, demonstrated by Friday’s jobs data smashing expectations with a 45,000 jobs rise in June, while real GDP growth is forecast at 2.8 per cent for 2017.

Despite the strong economic data, more cautious investors are wary of oil’s influence on Canada. It was the 2015 slump in the oil price that forced the BoC to make two 25 basis point rate cuts, underlining the sensitivity of the economy to commodity shifts. The central bank noted that the economy’s adjustment to lower oil prices “is largely complete”.

The BoC is now officially in the vanguard of those central banks other than the Fed that are pulling back from monetary stimulus. Behind the BoC comes the European Central Bank, the Bank of England and Norges Bank in considering a shift away from easy monetary policy.

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The currencies of Australia, New Zealand, Sweden have all gained against the US dollar thanks to strong economic growth, even if their central banks are cautious about changing policy quite yet. In contrast, the yen has been weakening against every other G10 currency as the Bank of Japan recommits to buying bonds and keeping the monetary spigot open.

Investors will now focus on whether the BoC move influences other central banks. “While there is no evidence to suggest that there is any collusion between central banks at present, game theory presents some reason for central banks to at least consider the actions of their peers in particular to reduce the risk of large swings in FX,” says Jane Foley at Rabobank.

The BoC’s upwards move is the first by a G10 central bank outside the Fed since the Reserve Bank of New Zealand raised rates three years ago, points out Alan Ruskin at Deutsche Bank.

Its decision is “unlikely to be an isolated affair for upcoming G10 tightenings,” he adds. “The market will view a rate hike in the context of other recent comments from other central banks (notably the ECB and BOE) that a removal of extreme accommodative policies may be warranted.”

Each central bank will adopt its own approach, but the speed of the BoC’s hawkish switch should be a warning to investors, says Mr Ruskin. “ . . . central banks are in a rare moment, where some core assumptions are being questioned and they are more open to change…”