Caution Pervades Ahead of the Bank of Canada’s Rate Decision

Canada’s economy hasn’t looked so robust since the collapse of oil prices in 2014. It’s evident in gross domestic product data, job growth, retail sales and even the much maligned manufacturing sector.

So, if things are so rosy in Canada, why are investors so down on the country’s outlook?

With Bank of Canada Governor Stephen Poloz making a rate decision Wednesday, here are the latest developments in the Canadian economy and the key issues informing policy makers.

State of Play

There are two key reasons why Canada’s economy is doing better. Oil prices have rebounded from last year’s lows and that’s giving energy-producing regions some life. Second, a housing boom in Vancouver and Toronto is fueling construction and creating billions in new found wealth for the city’s citizens.

Here’s the data:

  • The Bank of Canada is projecting output expanded at an annualized pace of 3.8 percent in the first quarter of this year, building off a 3.2 percent expansion in the second half of last year. These are heady levels of growth that are at the very high end of what Canada’s economy has been able to hit in the past 15 years. It’s also at the high end of growth for large rich nations.
  • The recent employment picture has been strong. The country has had positive job gains for six straight months, and since July has added 277,000 jobs. That’s almost as many jobs created as the previous two years. Other positive signs include hours worked numbers that show gains of 1.1 percent over the past 12 months and an unemployment rate — at 6.5 percent — that is the lowest since the recession.
  • Fueled by the job gains and feeling wealthier because of rising home values, Canadian households are spending. Retail sales in the first three months of 2017 were 6.3 percent higher than the same quarter last year. That’s almost double the pace of growth only a half a year ago. That’s a good sign for an economy in which consumption makes up 57 percent of output.
  • There are even signs of an improving picture for industrial Canada, the country’s weak spot for years. Factory shipments in March were up 8.2 percent from a year earlier, which was the fastest year-over-year pace since 2014.
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Plenty of Buts

Investors haven’t been too impressed however. The Canadian dollar is only one of two major currencies that have declined against the U.S. dollar this year. The only country Canada has out-performed is Brazil, which is in the middle of a political crisis.

In part, people are taking their cue from the Bank of Canada. Policy makers have been highlighting the risks and weakness of the economy for months, even in the face of improving data, and downplayed chances of higher interest rates even as borrowing costs increase in the U.S.

That’s one reason why the Canadian dollar has been weak. Interest rate differentials matter for currencies and with the U.S. central bank in the middle of a rate hiking cycle, and rates flat in Canada, investors have found the Canadian dollar less attractive.

Of 23 economists surveyed by Bloomberg News ahead of this week’s rate decision, none are predicting a rate increase Wednesday. The next rate hike in Canada isn’t likely to happen until the second quarter of 2018, economists predict.

Rate Rationale

The central bank’s reluctance to raise rates and its analysis has raised some eyebrows, especially given Canada’s economy is currently outpacing the U.S.

Poloz has been arguing that despite the recent acceleration in growth, Canada is still playing catch up to the U.S. economy. Canada’s march to full capacity was delayed by the oil price collapse, he argues, so it makes sense that growth will pick up and even exceed the rate of U.S. expansion. But that doesn’t diminish the need for lower rates.

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The governor has also been highlighting geopolitical uncertainties, and there is little evidence those are dissipating. There has been plenty for Canadians to chew over in the past week, including the start of the 90-day consultation period to renegotiate the North American Free Trade Agreement and a new spat with the U.S. over aerospace manufacturing.

The faster-than-expected growth in 2017, meanwhile, reflects temporary factors that won’t be replicated in the future, such as faster residential investment. The housing market is also the economy’s biggest source of financial stability risk, given elevated debt levels and all the trouble brewing over the situation at Home Capital Group Inc. Home-price growth slowed down in Toronto in the first two weeks of May, with sales falling 16 percent from last year amid a rush of new listings.

Plus, there is little evidence of inflation pressure, even with a pick-up in gasoline prices and the consistently elevated housing costs. The average of the central bank’s three core inflation measures — which exclude volatile items like energy and are considered a better indicator of trends in prices — declined to 1.4 percent in April, Statistics Canada said Friday.

While subdued price pressures are good for consumers, they also could reflect an economy with a lot of excess capacity where companies and workers have little scope to demand price increases or wage gains. That may provide central bankers with all the fodder they need to remain cautious in their statement Wednesday.

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