GLOBAL ECONOMICS SCOTIA FLASH

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1 Hawkish BoC Hikes And Warns Of More To Come CONTACTS As expected the BoC hiked its policy rate by 25bps to 1.25% and that s the right thing to have done in my opinion. My read of the overall bias in the full suite of communications including the statement, MPR and press conference is mildly hawkish as the BoC lowered the bar for further rate hikes on balance. OIS markets are pricing most of another hike by April/May which is in keeping with our forecast for timing the next policy move, and two more in total this year which is also in keeping with our forecast. CAD is about a half cent stronger versus the USD than it was earlier this morning after netting out position covering on moves immediately prior to the statement and after digesting all of the information provided by the BoC in its full communciations. A stronger currency in the aftermath makes sense to me. There is nothing in the broad set of communications that stands in the way of further hikes in the relatively near-term. This is a more hawkish statement than markets were anticipating over recent days and it stands to repeat that the overall communications incrementally lowered the bar for further hikes. With the following comment, the door is wide open to further rate hikes: 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. That just says they re open to more hikes but not zipping toward neutral faster than we forecast. This merits elaboration. Do not misinterpret continued monetary policy accommodation. Continued monetary accommodation speaks to the spread between the pace of future hikes and a neutral policy rate estimate and should not be interpreted as a dovish signal against the warrant higher interest rates over time remark. The BoC can still keep hiking and maintain monetary policy accommodation by remaining below a neutral rate this year and that s all that this comment implies. The BoC upgraded its assessment of slack to note that the economy is operating roughly at capacity whereas in December it was still emphasizing the continued absorption of economic slack. This is hawkish. The BoC upgraded its perspective on labour slack and now says labour slack is being absorbed more quickly than anticipated. This is hawkish. Global forecasts were revised up and pretty significantly in several cases and this provides an incrementally more hawkish backdrop to then back into implications for the Canadian economy. The US outlook was revised up to 2.6% growth this year (2.2% previously) and by a tick to 2.3% next year. The Eurozone s growth outlook was revised up four tenths this year to 2.2%. Japan was also revised up and China was kept flat at 6.4% and 6.3% projected growth this year and next. Therefore the global outlook strengthened in this MPR which is a hawkish signal. The BoC upgraded its language on inflation by stating that looking through these temporary factors, inflation is expected to remain close to 2 percent over the projection horizon. It did not previously advise it was looking through as clearly as it did today and so this is incrementally hawkish. Derek Holt, VP & Head of Capital Markets Economics Scotiabank Economics derek.holt@scotiabank.com 1

2 Furthermore, in the press conference, the BoC somewhat hawkishly noted: "As the Governor noted in a speech last November, a number of economists and policy-makers have been struggling to explain weaker-than-expected inflation in many jurisdictions. This has not been the case here in Canada, where core inflation measures have been increasing and behaving largely as we would have expected." It is a hawkish signal that the BoC rejects any notion that in Canada the connection between spare capacity and inflation has weakened or broken down as it may have elsewhere. The BoC slightly upgraded its Canadian economic growth forecast by a tick in each of 2018 and 2019 to 2.2% and 1.6%. Regardless of the risks, the BoC nets out to a slightly improved growth profile for Canada and that is slightly more hawkish. There are nevertheless four ways in which the BoC retained some caution but they are not impediments to the broader messages above that support further tightening and they are not always consistent. They are as follows. 1. On NAFTA, I found the BoC s communications to be marginally coherent at best. The statement appeared to upgrade NAFTA uncertainties. But the press conference statement noted: "Consistent with this approach, our outlook is based on the premise that current trade agreements will remain in place over the projection horizon. There are still a wide range of possible outcomes, which could play out over many different timelines. We do not know how the talks will conclude, and we do not know how governments will react to whatever outcome is reached. This means that trying to quantify any particular scenario would not be useful at this point for monetary policy purposes. " And yet negative forecast judgement was applied to the outlook because of NAFTA risks. Well, which is it: you don t know how to quantify it, but you re going to do so negatively anyway? This is arbitrary on behalf of the BoC. It is especially arbitrary when one could easily argue that the timing of applying negative forecast judgement on NAFTA risks is unusual in multiple respects. Governor Poloz just dropped it as a key risk keeping him awake at night in his December speech but now it s back front and centre. Further, the news on NAFTA has actually improved of late (e.g. Trump s no rush and his comment to push out negotiations to after the Mexican election, after which the US is in full-on mid-term election mode and then full grid-lock may return to Washington). Also, businesses are not indicating any impact on investment plans but the BoC increased its negative judgement on model growth forecasts by assuming it knows better than the companies devising said investment plans? Perhaps, and time will tell one way or the other. Furthermore, when asked in the press conference what matters more, NAFTA or data dependence, Poloz stated We remain fully data dependent. He went on to firmly guide that data trumps NAFTA if you will. So the BoC is applying negative judgement that we don t know will materialize one way or the other but we ll ignore that in favour of near-term data readings of a backward looking fashion in any event. The key point to fall out of this is that if this judgement lifts as data remains resilient to NAFTA and sundry other risks then the BoC will be forced to lift this negative judgement which could shift its guidance to becoming incrementally more hawkish over time. Against heightened NAFTA-related negative forecast judgement, BoC guidance on other uncertainties was more mixed. Note what is not here: there is zero reference to CAD strength. When the BoC has been worried about it in the past, it has codified concerns in the statement and it did not this time around. That says the BoC is comfortable with CAD strength driven by fundamentals but they could easily have cautioned on CAD. Also note that household debt concerns were not explicitly mentioned in the statement as they were not in the December statement, but they were not escalated either in terms of the sensitivity to higher interest rates remark in the concluding paragraph that was unchanged. Indeed, Wilkins noted household debt sensitivities in the press conference but it was more as a vulnerability to an unanticipated shock than a vulnerability to gradual rate hikes. 2. Potential GDP growth estimates were revised up a tick to 1.6% this year and next but that simply offsets the upward revision to actual GDP growth in each year. The level of potential GDP was revised up by only 0.2% as at 2017Q3 which is fairly trivial and still leaves capacity swinging into net excess demand this year as actual growth outstrips potential growth by about six-tenths in Further, it s a bit questionable that the BoC revised up its potential growth estimate by a tick but didn t change the range accordingly which sits unchanged at % this year and % next year. The BoC s discussion on potential growth uncertainties and how improving capital investment and productivity trends might raise the economy s non-inflationary speed limit is on the minds of many, but a) they may have simply undershot potential growth estimates in the past, and b) at this point they are indicating the bias is toward less slack in terms of how it all nets out. 2

3 3. The BoC retained reference to how it will remain cautious toward future policy moves as expected and retained data dependent guidance when it said it will be guided by incoming data in assessing the economy s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. 4. On wages, the BoC issued this paper that indicates an altered preference for the most relevant wage metric. The BoC used to always say wage gains for permanent employees was the preferred measure in the past, but now guides that a common trend measure is preferred. That measure at 2.2% y/y versus the permanent employees measure of 2.9% y/y is why Poloz now argues that real wage gains are small to absent thus far instead of rising. Regardless, our view is that either measure of wage growth is likely to continue rising this year given reduced labour slack, the further shaking out of the negative drag from the commodity income shock, productivity gains over time and full knock-on effects of minimum wage hikes. The wage cycle in a forward looking sense should reinforce broader inflationary pressures regardless of the measure that is used. The next BoC statement will be on March 7 th and we expect no rate move at that meeting. The next BoC communications will include a speech by Senior Deputy Governor Wilkins on February 8 th and a speech by Deputy Governor Schembri on February 15 th. Please see the attached statement comparison. 3

4 RELEASE DATE: JANUARY 17, 2018 The Bank of Canada today increased its target for the overnight rate to 1 1/4 per cent. The Bank Rate is correspondingly 1 1/2 per cent and the deposit rate is 1 per cent. Recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity. However, uncertainty surrounding the future of the North American Free Trade Agreement (NAFTA) is clouding the economic outlook. The global economy continues to strengthen, with growth expected to average 3 1/2 per cent over the projection horizon. Growth in advanced economies is projected to be stronger than in the Bank s October Monetary Policy Report (MPR). In particular, there are signs of increasing momentum in the US economy, which will be boosted further by recent tax changes. Global commodity prices are higher, although the benefits to Canada are being diluted by wider spreads between benchmark world and Canadian oil prices. In Canada, real GDP growth is expected to slow to 2.2 per cent in 2018 and 1.6 per cent in 2019, following an estimated 3.0 per cent in Growth is expected to remain above potential through the first quarter of 2018 and then slow to a rate close to potential for the rest of the projection horizon. Consumption and residential investment have been stronger than anticipated, reflecting strong employment growth. Business investment has been increasing at a solid pace, and investment intentions remain positive. Exports have been weaker than expected although, apart from cross-border shifts in automotive production, there have been positive signs in most other categories. Looking forward, consumption and residential investment are expected to contribute less to growth, given higher interest rates and new mortgage guidelines, while business investment and exports are expected to contribute more. The Bank s outlook takes into account a small benefit to Canada s economy from stronger US demand arising from recent tax changes. However, as uncertainty about the future of NAFTA is weighing increasingly on the outlook, the Bank has incorporated into its projection additional negative judgement on business investment and trade. The Bank continues to monitor the extent to which strong demand is boosting potential, creating room for more noninflationary expansion. In this respect, capital investment, firm creation, labour force participation, and hours worked are all showing promising signs. Recent data show that labour market slack is being absorbed more quickly than anticipated. Wages have picked up but are rising by less than would be typical in the absence of labour market slack. In this context, inflation is close to 2 per cent and core measures of inflation have edged up, consistent with diminishing slack in the economy. The Bank expects CPI inflation to fluctuate in the months ahead as various temporary factors (including gasoline and electricity prices) unwind. Looking through these temporary factors, inflation is expected to remain close to 2 per cent over the projection horizon. 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. Governing Council will remain cautious in considering future policy adjustments, guided by incoming data in assessing the economy s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. RELEASE DATE: DECEMBER 6, 2017 The Bank of Canada today maintained its target for the overnight rate at 1 per cent. The Bank Rate is correspondingly 1 1/4 per cent and the deposit rate is 3/4 per cent. The global economy is evolving largely as expected in the Bank s October Monetary Policy Report (MPR). In the United States, growth in the third quarter was stronger than forecast but is still expected to moderate in the months ahead. Growth has firmed in other advanced economies. Meanwhile, oil prices have moved higher and financial conditions have eased. The global outlook remains subject to considerable uncertainty, notably about geopolitical developments and trade policies. Recent Canadian data are in line with October s outlook, which was for growth to moderate while remaining above potential in the second half of Employment growth has been very strong and wages have shown some improvement, supporting robust consumer spending in the third quarter. Business investment continued to contribute to growth after a strong first half, and public infrastructure spending is becoming more evident in the data. Following exceptionally strong growth earlier in 2017, exports declined by more than was expected in the third quarter. However, the latest trade data support the MPR projection that export growth will resume as foreign demand strengthens. Housing has continued to moderate, as expected. Inflation has been slightly higher than anticipated and will continue to be boosted in the short term by temporary factors, particularly gasoline prices. Measures of core inflation have edged up in recent months, reflecting the continued absorption of economic slack. Revisions to past quarterly national accounts have resulted in a higher level of GDP. However, this is unlikely to have significant implications for the output gap because the revisions also imply a higher level of potential output. Meanwhile, despite rising employment and participation rates, other indicators point to ongoing albeit diminishing slack in the labour market. Based on the outlook for inflation and the evolution of the risks and uncertainties identified in October s MPR, Governing Council judges that the current stance of monetary policy remains appropriate. While higher interest rates will likely be required over time, Governing Council will continue to be cautious, guided by incoming data in assessing the economy s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. 4

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