Dave Larock in Interest Rate Update, Mortgages and Finances
The Bank of Canada (BoC) raised its policy rate by 0.25% last week, and it now stands at 1.25%.
Lender prime rates responded in predictable lock step and that meant that variable-rate borrowers had to absorb their third 0.25% rate increase in less than seven months, after enjoying seven years without any hikes.
Variable-rate borrowers are certainly having their courage tested of late, especially with the mainstream media making ominous predictions about more rate increases on the horizon. But will these warnings prove prescient?
After reading the BoC’s accompanying press statement, and more importantly, its latest Monetary Policy Report (MPR), I am sceptical. The latest rate hike was widely expected, but the Bank’s more dovish outlook was not (except by this blogger).
In the lead up to the BoC’s latest meeting, the consensus view from mainstream economists was that the Bank would hike its policy rate between three and four times in 2018. But in its latest MPR the BoC threw plenty of cold water on that forecast, and bluntly put, barring any unexpected surprises in the months ahead, more near-term rate hikes seem highly unlikely.
In today’s post I’ll provide the highlights from the BoC’s latest policy statement and MPR, along with my own observations, to explain why I hold that view.
Highlight from the BoC’s Latest Statement
- “The Canadian economy is operating close to its potential level of activity, and inflation is close to the 2 per cent target.”
MPR Background Detail
While overall inflation is now a little above the official 2% target, at 2.1% today it is still well within the BoC’s desired range of 1% to 3% and the Bank did not sound overly concerned about higher-than-expected inflation. Instead, it noted “slowly building inflationary pressures”.
The Bank expects that “temporary factors” will cause inflation “to fluctuate over the near term” but that it will “remain close to 2% over the projected horizon”. In other words, the BoC isn’t going to over-react to near-term volatility in the inflation data.
Recent wage growth has fuelled speculation that more BoC rate hikes may be imminent, but the Bank is predicting that additional gains will be constrained by an “elevated long-term unemployment rate and relatively low youth participation rate [which] suggest an availability of additional labour resources over and above the natural expansion of the labour force”. In other words, the Bank thinks there will be more available labour than the official unemployment rate implies, and to wit, it noted that the “composite indicator” that it uses to measure employment conditions “has fallen by less than the unemployment rate”.
The Bank believes that global competition “is likely leading to more outsourcing and automation” and that this is “weighing on wage growth”. It also recently estimated that the recent minimum wage hikes in British Columbia, Alberta and Ontario will also cost our economy about 60,000 jobs by 2019.
The BoC raised its inflation forecast from 1.7% to 2.0% in 2018, but left its previous forecast for 2019 unchanged at 2.1%.
Highlight from the BoC’s Latest Statement
- “Growth around the world continues to strengthen and broaden, supporting the expansion here at home. We have upgraded the outlook for the US economy due to greater momentum and the new tax legislation passed late last year.”
MPR Background Detail
The BoC increased its projected GDP growth for the U.S. economy from 2.2% to 2.6% in 2018 and from 2.0% to 2.3% in 2019, citing “stronger momentum and recent tax reform legislation”.
I am much less sold on the recent improvement in the U.S. economic data because it was underpinned by a surge in consumer spending that corresponded with a spike in credit-card borrowing and a sharp decline in the U.S. personal saving rate. Also, U.S. inventories surged in the fourth quarter, and those inventories will now need to be drawn down at the expense of future growth.
The recently enacted tax cuts that are fuelling bullish forecasts are being paid for by an increase in the U.S. federal government’s budget deficit, and that increased debt will choke off future growth. Furthermore, while many predict that the corporate tax cuts will stimulate a rise in business investment, U.S. companies have been far more inclined to use their excess cash to fund share buy backs and/or to raise their dividends over the past several years, and that’s what I expect most of them to do with their newfound tax saving. If I’m right, the corporate tax cuts won’t have nearly the stimulative impact that the consensus expects.
The BoC is calling for Chinese GDP to fall from 6.8% in 2017 to 6.4% in 2018 and to 6.3% in 2019.
As the Chinese economy slows, demand for most commodities should slow along with it. Today commodity prices are rising, and that is giving a boost to our economy, but if China’s economic momentum slows, commodity prices are likely to fall and that will turn one of our current tailwinds into a headwind going forward.
Highlight from the BoC’s Latest Statement
- “In Canada, economic growth is expected to average around 2 1/2 per cent in the short term, before slowing to a more sustainable pace over the projection horizon. This outlook remains clouded by uncertainty related to the future of the North American Free Trade Agreement (NAFTA).”
MPR Background Detail
The BoC expects “growth from household spending … to decline … [and] robust employment gains and growth in household income … to slow”.
The Bank raised its GDP growth forecast for our economy from 2.1% to 2.2% in 2018 and from 1.5% to 1.6% in 2019.
To account for this rise, the BoC raised its forecast for consumption as percentage of our overall GDP growth from 1.3% to 1.6% in 2018 and for housing from 0% to 0.1% over the same period. That means that the Bank expects consumption and housing to account for 1.7% of our overall GDP growth of 2.2% in 2018.
The BoC is forecasting that our overall GDP growth will drop from 2.2% in 2018 to 1.6% in 2019 and not surprisingly, it expects that consumption will take the biggest hit as the full impact of the three recent policy-rate increases and the implementation of the sixth round of mortgage rule changes bite.
This is significant for the year ahead because if the BoC is projecting a lag between now and the time when both the monetary and macro-prudential changes start to materially impact our economy, it is less likely to make more changes in the interim. Especially if it believes that the eventual impact will be significant enough to knock 25% off of our overall GDP growth rate.
When the Loonie rises, it impacts our economy in much of the same ways that rate rises do, and it is once again trading at more than 80 cents versus the Greenback. Additional BoC policy-rate increases are likely to push the Loonie higher still, and that will magnify the impact of additional rate rises on our economic momentum.
On a related note, the Bank left its forecast for exports (as a percentage of GDP growth) flat at 0.6% in 2018 and increased it from 0.8% to 0.9% in 2019. This is in spite of the Loonie’s recent rise, and more importantly, notwithstanding that Bank’s concerns about the negative impact that the NAFTA negotiations are having on this sector. Over the short term, the BoC observed that “prospects for exports have improved in light of the stronger US outlook and higher commodity prices” but the main theme in the latest MPR centred around the lasting damage that the ongoing NAFTA negotiations are having on our economic momentum.
In his accompanying press conference, BoC Governor Poloz noted that current business investment intentions are already being impacted by NAFTA uncertainty, and he speculated that companies who do business on both sides of the border are probably more inclined to invest in U.S. expansion until the trade picture becomes clearer. U.S. President Trump has indicated his willingness to delay a decision on NAFTA until after the Mexican election in July and that makes it likely that trade uncertainty will last well into 2018. Given that, even if NAFTA is ultimately preserved, the current uncertainty that surrounds its status may well have had a lasting negative impact on our economic momentum.
The BoC also believes that the current risks to oil prices “are tilted to the downside” because U.S. oil production “has been increasing strongly” and “could be even stronger”. If oil prices fall, this will create a powerful headwind for our energy sector.
Highlight from the BoC’s Latest Statement
- “Council will therefore 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.”
MPR Background Detail
When the BoC uses the word “cautious” in its closing statement it’s a pretty clear signal to markets that it plans to take its time over the near term. But how much time?
BoC Governor Poloz previously estimated that it can take anywhere from one to two years before the economic data reflect the full impact of its policy-rate rises and, barring any surprise developments, I think the Bank will now wait for longer than the consensus expects before seriously considering another hike.
This view is also bolstered by our elevated household debt levels, which heighten our “economy’s sensitivity to interest rates”. Governor Poloz has repeatedly said that the Bank won’t have to tighten by as much as in past cycles to slow our economy.
The BoC estimates that our maximum potential output will grow by an “average 1.6% over the 2018-2019 projection horizon” and it is forecasting that our GDP growth will be 1.6% over the same period. If these projections hold and our maximum potential output expands at about the same rate as our actual output, that will keep us in Governor Poloz’s “inflationary sweet spot” and extend our economy’s runway of non-inflationary growth well into the future.
The BoC wants to take time to observe “the dynamics of both wage growth and inflation” but despite the market’s enthusiasm for the most recent employment report, the Bank assesses that “underlying wage pressures remain modest” and it expects “recently robust employment gains … to slow”.
The Bottom Line: After reviewing the BoC’s latest detailed assessment of our economy, I think that the warnings of more near-term variable-rate increases are off the mark. I think the Bank will allow time for its last three rate hikes to take effect and will wait for the drawn-out NAFTA negotiations to run their course.
David Larock is an independent mortgage broker and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear on Mondays on this blog, Move Smartly, and on his own blog, Integrated Mortgage Planners Email Dave
January 22, 2018
Mortgage |