Bank of Canada hikes rate as economy stays strong, trade uncertainty recedes

interest rate
interest rate

The Bank of Canada hiked its trend-setting interest rate Wednesday as the resilient economy hums along and a big source of trade uncertainty is finally out of the way.

The central bank delivered a quarter-point rate increase for the fifth time since the summer of 2017 – and first time since July – to bring the benchmark to 1.75 per cent. The rate is now higher than it’s been in about a decade.

It was the central bank’s first policy decision since Canada agreed with the United States and Mexico earlier this month on an updated North American free trade deal.

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“The new U.S.-Mexico-Canada Agreement (USMCA) will reduce trade policy uncertainty in North America, which has been an important curb on business confidence and investment,” the bank said in a statement Wednesday.

“The Canadian economy continues to operate close to its potential and the composition of growth is more balanced.”

The removal of one of the trade-uncertainty shackles also coincided with a notable change in the wording of the statement Wednesday, compared with the bank’s recent policy news releases.

This time around, the bank omitted the word “gradual” from its explanation on how it will approach future rate increases, a change that could lead some observers to anticipate future hikes will come faster than the market had previously expected.

Looking ahead, the bank indicated more increases will be needed to bring the rate to a “neutral stance” in order to keep inflation from rising too far above its ideal two per cent target. Governor Stephen Poloz’s team has pegged the neutral rate at between 2.5 and 3.5 per cent, so several more increases are likely on the way.

The statement, however, noted the pace of future increases will continue to be guided by how well households are digesting the higher interest rates, given their high levels of debt.

So far, the bank said Canadians have been making spending adjustments in response to earlier rate hikes and stricter mortgage policies – and credit growth continues to moderate.

“As a result, household vulnerabilities are edging lower in a number of respects, although they remain elevated,” the statement said.

The bank still expects consumer spending to continue expanding at a “healthy pace,” thanks in large part to the steady rise of incomes and high consumer confidence.

Until the hike Wednesday, the interest rate hadn’t been above 1.5 per cent since December 2008. At that time, during the financial crisis, the bank made a three-quarter-point cut to the benchmark, bringing it to 1.5 per cent from 2.25 per cent.

The bank left the rate unchanged in September and senior deputy governor Carolyn Wilkins later said the unknown consequences of the continental trade talks – as well as the tit-for-tat tariff dispute – were front and centre in the decision.

Following the USMCA agreement, the bank now expects lingering trade tensions – such as U.S. metals tariffs and Canada’s countermeasures – to lower business investment by just 0.7 per cent by the end of 2020, compared with the 1.4 per cent reduction it had predicted in July. Exports are now expected to take a negative hit of just 0.3 per cent compared to the previous prediction of a 0.7 per cent reduction.

The bank pointed to data that indicates the tariff quarrel has led to reductions in steel exports and imports, but have yet to show a notable impact on aluminum shipments.

The projections were laid out in the latest edition of bank’s quarterly monetary policy report, which was also released Wednesday.

The report predicted business investment – outside the oil and gas sector – will expand due to solid domestic and foreign demand.

It noted, however, Canada is still grappling with competitiveness challenges linked to major U.S. tax and regulatory changes as well as ongoing uncertainties around pipeline approval. The bank anticipates these factors will encourage some exporters to delay their investments or to make them outside Canada.

Exports are expected to continue growing at a moderate clip, the bank said, but they will face limitations from several factors – including transportation capacity constraints, global trade uncertainty and stiff competition, particularly from the U.S.

In a batch of updated economic forecasts, the bank predicted Canada’s real gross domestic product to expand 2.1 per cent in 2019, down from its July call of 2.2 per cent, and by 1.9 per cent in 2020. Its growth projection for this year has been increased slightly to 2.1 per cent, up from its previous prediction of two per cent.

Inflation, which reached 2.7 per cent in the third quarter of 2018, is expected to slide back close to two per cent by next spring as temporary effects from higher air fares, pricier gasoline and minimum wage hikes in some provinces fade away. The bank noted that core inflation readings, which omit more volatile items like pump prices, have stayed close to two per cent.

The report also noted that the economic activity generated by the recent legalization of recreational cannabis will likely have just a small impact on monetary policy decisions.

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