On Hold, Maybe for a While: Why the Bank of Canada Thinks Interest Rates are ‘Appropriate’

Appropriate. That is how the Bank of Canada (BOC) judges the current level of interest rates in Canada, and it is how we judge them as well. In its latest pronouncement on monetary policy, the BOC left its benchmark ‘overnight’ rate at 0.5 percent, and in its accompanying statement gave a cautious but mostly positive outlook for Canada’s economy.

Cautious but mostly positive seems a fitting way to describe our views on Canada’s economy and housing sector as well. We agree with the BOC that there are existing risks to the outlook, but overall it appears that the monetary policy is at the right level. In fact, reviewing the Bank of Canada’s assessment, it could be that they judge interest rates to be at the right level for quite some time to come.

What the Bank of Canada Said

The BOC’s statement was short and to the point. In October the BOC gave us a fleshed-out view of the economy with their Monetary Policy Report and with this latest statement they simply rubber-stamped it, saying that global economic growth is evolving essentially as they had anticipated. Positively, they classify the U.S. economy as growing at a solid pace, but make note that the domestic side of things – consumer spending and investment – is proving to be less robust than expected.

In Canada, our biggest economic challenge of the past year has been the slide in oil prices, and going forward is likely to be the fact that those prices are unlikely to recover soon. The BOC acknowledges that in their remarks, saying that ‘The economy continues to undergo a complex and lengthy adjustment to the decline in Canada’s terms of trade.’ They note that the strengthening U.S. economy is helping, as is the lower Canadian dollar. Both of those are factors that will ultimately help our exports, particularly those in the non-resource industries. Still, they acknowledge that lower business spending by the resource sector, which took us into a technical recession earlier this year, is going to be an ongoing problem.

In the labour market there is also a dual story to tell: decent job gains in the areas of the country that can benefit from the U.S. recovery and the exchange rate; and job losses in resource-dependent areas. Although this time around the BOC does not mention housing at all, they could have made a similar statement about Canada’s regional housing markets. We continue to see strong activity in most of Canada’s housing markets, with prices beginning to slide modestly in select markets where consumer confidence and employment is tied tightly to the energy sector.

As to where the economy is going from here, the BOC is looking for growth in gross domestic product to come down a notch in the final quarter of this year, before moving to a rate ‘above potential’ in 2016. That’s actually a rather important statement. In normal circumstances, any mention of growing above potential might be a hint that interest rates need to start moving higher. This time around, however, that does not seem to be the case.

The real story for the BOC is that inflation is not really an issue, and as long as that is true we are unlikely to see any change to interest rates. The BOC sets a target range as to where inflation should be and as of their last update they see it as near the bottom of that range. As they noted, the same decline in commodity prices that is causing problems in western Canada is also resulting in lower prices to consumers. With the economy still too weak for retailers to raise prices much, the lower Canadian dollar is not currently causing price hikes.

The big picture is that Canadian rates look to be on hold, possibly for right through 2016. Following two cuts to interest rates in 2015 some market observers think that that the Bank will opt to cut rates one more time, but there is little in this statement to suggest that that might be the case. In fact, they note that ‘vulnerabilities in the housing sector ‘continue to edge higher’, which can be taken as an acknowledgement that further monetary stimulus would not be desirable for Canadians living in Vancouver and Toronto, where the market has been expanding at a much quicker rate than the underlying economy. If that is a clear concern of the BOC, then a further interest rate cut is not likely in the cards.

‘Taking all of these developments into consideration, the Bank judges that the risks to the outlook for inflation remain within the zone for which the current stance of monetary policy is appropriate’ reads the statement. ‘Therefore, the target for the overnight rate remains at 1/2 per cent.’

That states it clearly, there will be no change to interest rates for now, and presumably little change in retail mortgage rates.

Where Do We Go From Here?

Given that interest rates are one of the most important drivers of the housing market, the BOC’s decision to leave rates alone at a very low level is positive for housing, even if, the outlook for economic growth is tepid. For now, we thankful that inflation remains a non-issue and that interest rates can remain very low. We do look forward to the time when solid economic growth and employment advances across the country are driving the market forward, even if that means that interest rates had to edge up a bit.

As we head into 2016, do expect that American interest rates will begin to climb modestly, on the back of sustained jobs growth. In a country that sees net benefit when commodity prices fall, the U.S. economy has been boosted rather than slowed by the recent dip in energy prices. With dropping unemployment, the labour market is getting tighter and the first signs of salary and wage inflation are appearing south of the border. It is very likely that the U.S. will nudge interest rates higher either this month or early in 2016. In turn, that might put further downward pressure on the Canadian dollar, presumably helping the export sector here, but increasing the cost of imported goods and services.

The BOC will also no doubt be keeping close watch on the policies implemented by our newly-elected federal government. If Prime Minister Trudeau moves to fulfill his election promises early in his mandate and begins to stimulate the economy through infrastructure investment, there will be little need for a cut to Canadian rates. Put in economists’ terms, if fiscal policy is stimulative, then monetary policy does not need to be.

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