Bank of Canada Takes First Cautious Step Toward Higher Rates (3)

(Bloomberg) — Canada cautiously became the first Group of Seven country to join the U.S. in raising interest rates on Wednesday, feeding speculation the world’s central bankers are entering a tightening cycle.

The central bank raised its benchmark rate to 0.75 percent from 0.5 percent, while adding an element of prudence by warning future rate hikes will be “guided” by the data.

Investors are looking at the decision as a possible harbinger of things to come globally and are monitoring it for clues on the central banks’ resolve for withdrawing stimulus, with the prospect of tightening triggering a selloff in government bond markets over the last two weeks. Canadian government bond yields and the country’s currency rose after the hike, on expectations the Bank of Canada will follow with a second increase this year.

“Monetary policy is not on a predetermined path,” Governor Stephen Poloz said in opening remarks ahead of a press conference in Ottawa. Later, he said he didn’t doubt that interest rates would be higher over time. “It will remain highly data-dependent as we move forward,” Poloz said.

Canada is in the midst of one of its strongest growth spurts since the 2008-2009 recession, with the expansion accelerating to an above-3 percent pace over the past four quarters. That’s the fastest among G-7 countries and double what the central bank considers Canada’s capacity to grow without fueling inflation.

The acceleration in growth, and its broadening to more sectors and regions, has increased “confidence” the economy will continue to absorb excess capacity, the Bank of Canada said. The central bank estimated the economy will return to full capacity by the end of 2017.

Read more from our TOPLive blog of the rate decision.

“Governing Council judges that the current outlook warrants today’s withdrawal of some of the monetary policy stimulus in the economy. Future adjustments to the target for the overnight rate will be guided by incoming data as they inform the bank’s inflation outlook, keeping in mind continued uncertainty and financial system vulnerabilities,” the bank said in its statement.

The stronger economy also means policy makers can finally begin the process of weaning the nation from cheap credit that has driven home prices to unaffordable levels, left the nation’s households with record debt and exposed Canada to a financial crisis.

Market Reaction

How quickly Poloz normalizes rates is still an open question. Markets have about fully priced in a second rate hike by December, which would fully reverse the two cuts Poloz made in 2015 to counter the effects of falling oil prices, according to Mark Chandler, head of fixed income research at Royal Bank of Canada. A third rate hike is priced in by the end of 2018.

The Canadian dollar jumped 1.6 percent, to its highest level in a year. Two-year Canadian government bonds jumped 7 basis points to 1.19 percent, the highest since November 2013.

“The market took it hawkishly both in terms of rates and the currency,” Chandler said.

At the press conference, Poloz said he would “hesitate” to classify the move Wednesday as the first step in a longer rate normalization process, or as part of efforts to remove the 50-basis-point stimulus from 2015.

“Our assessment is that the economy can handle very well this move we had today,” Poloz said, adding that interest rates are still low and will rise over time. “It’s a data dependent, quarter-by-quarter analysis that we’ll be doing.”

Sluggish Inflation

There are reasons for the Bank of Canada to remain cautious. Not only has inflation been sluggish, it’s also been weakening with consumer prices in May up 1.3 percent on an annual basis — the slowest pace this year.

The central bank downplayed that recent weakness, judging the sluggishness as “mostly temporary,” and predicted inflation will return “close to” its target of 2 percent by the middle of 2018. Excluding temporary factors, inflation is at about 1.8 percent, Poloz said, adding that in fact price increases by 2019 are projected to overshoot the central bank’s mandated target.

Another reason to pause may be the Canadian dollar’s sudden assent, which could add as a headwind to growth — an issue Poloz didn’t touch on much Wednesday.

What Poloz did spend a lot of time on is highlighting how the bank will pay close attention to how higher interest rates will impact indebted households. At the press conference, the governor said he will gauge “carefully the effects of higher interest rates on the economy.”

High household debt levels may be one of the biggest obstacles to moving too quickly.

(Updates throughout.)

–With assistance from Luke Kawa Erik Hertzberg and Greg Quinn

©2017 Bloomberg L.P.

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