Bank of Canada signals next rate hike is on the horizon

Interest rate

The Bank of Canada kept its key interest rate target on hold Wednesday, but noted the Canadian economy was a little stronger than expected in the first quarter, raising expectations that rate hikes are coming later this year.

The central bank held steady its target for the overnight rate – a key financial benchmark that influences the prime lending rates at the country's big banks – at 1.25 per cent.

However, economists said the Bank of Canada's decision to drop a reference to remaining "cautious" signalled a more hawkish tone and suggested that the next rate increase would be soon.

"All told, the positives seem to outweigh the negatives," TD Bank senior economist Brian DePratto wrote in a note to clients.

"Gone was the reference to 'caution' that typified the last few statements. Today's statement instead chose the term 'gradual' to describe the approach to policy adjustments."

The loonie was up 0.74 of a US cent to average 77.54 cents US, thanks largely to the change in the bank's tone, said Allan Small, a senior investment adviser at HollisWealth.

"They did not raise rates this go round, but they basically gave an indication or at least a hint that they still believe that they need to raise interest rates in the future to combat an economy that's heating up, to combat the fear of inflation."

The Bank of Canada's next scheduled interest rate decision is set for July 11 when it will also update its outlook for the economy and inflation in its monetary policy report.

In announcing its decision Wednesday, the central bank said exports were more robust than forecast as data on imports of machinery and equipment suggest continued recovery in investment, but also pointed to softer real estate activity into the second quarter as the market "continues to adjust to new mortgage guidelines and higher borrowing rates."

"Going forward, solid labour income growth supports the expectation that housing activity will pick up and consumption will continue to contribute importantly to growth in 2018," it said.

The Bank of Canada also said global economic activity remains broadly on track, but added that ongoing uncertainty about trade policies is dampening global business investment and stresses are developing in some emerging market economies.

It noted that recent developments have reinforced its view that higher rates will be warranted to keep inflation near its target, but added that it will take a gradual approach and be guided by the economic data.

"In particular, the bank will continue to assess the economy's sensitivity to interest rate movements and the evolution of economic capacity," it said.

Alicia Macdonald, principal economist at the Conference Board of Canada, has been expecting since January that the Bank of Canada will raise its key interest rate in July.

She said Wednesday that there's now a possibility the central bank may also increase the rate in September or October, but that will depend on what happens with the trade talks with the United States and Mexico.

"We think there's reason to still think they might be cautious as they wait for these events to unfold," she said.

Macdonald also said she'll be watching what happens with the housing market, which she said the Bank of Canada expects to rebound over the rest of this year.

"We think that, yes, it won't be as bad going forward, but we do see the possibility for some continued softness in housing market activity over the next few months and that could weigh on future rate increases," she said.

However, David Watt, HSBC's chief economist for Canada, said he expects the Bank of Canada to keep its key interest rate on hold for the rest of the year.

"In our view, the Bank of Canada's hawkishness is premature," he wrote in a report.

Watt cited moderate job growth, lacklustre non-energy export growth, ongoing trade policy uncertainty, subdued capital expenditures and signs households are being squeezed by past rate increases and high gasoline prices as reasons the central bank would keep its rate unchanged.

The central bank's decision to keep its trend-setting rate on hold came as inflation sits above the two per cent midpoint of its target range of one to three per cent and core inflation has crept past the two per cent mark for the first time since 2012.

It noted that inflation will likely be a bit higher in the near term than was forecast in its April monetary policy report due to recent increases in gasoline prices, but that it will look through the transitory impact of the fluctuations at the pump.

The central bank has raised its key rate three times since last summer, increases that have prompted the big Canadian banks to raise their prime rates which are used to set the rates charged for variable-rate mortgages and other variable-rate loans.