By: Adrian Moore – Forex Focus
The monetary-policy committee maintains status quo at 1.25 percent in May.
Aligning with market expectations, the Bank of Canada (BoC) left its benchmark interest rate unchanged at 1.25 percent and the deposit rate at 1.0 percent, following the conclusion of its monetary-policy meeting on May 30. This is the third time in a row that the bank has resorted to maintaining the status quo on policy rates, after having increased the rate from 1.0 to 1.25 percent in January of this year. However, the central bank governor, Stephen Poloz, signaled that the bank may go ahead with a rate hike during the upcoming monetary-policy meeting to be held in July.
The overnight policy interest rate in Canada
The Bank of Canada carries out its monetary policy by influencing the short-term rates in the economy. This is done by raising or lowering the overnight policy interest rate. Most major banks in Canada fall under the Large Value Transfer System (LVTS), an electronic system used by the banks to conduct large transactions with each other. These accounts need to be settled every day. Because the amount of money with banks can vary based on their lending activities and daily customer withdrawals and deposits, banks may experience shortages or surpluses of cash at the end of a business day. In order to maintain a cash balance and keep its accounts settled, the bank facing a shortage borrows from banks with surpluses. This helps maintain stability and liquidity in the entire banking system. This borrowing and lending on a one-day basis takes place at the overnight policy interest rate.
This overnight rate is influenced by the Bank of Canada to achieve its monetary-policy objectives. This primarily involves keeping inflation near 2 percent, or close to the 1-to-3 percent band. Since November 2000, the bank has fixed eight dates each year on which it announces changes in the overnight rate. An increase in the overnight rate makes it more expensive for banks to settle their accounts. In order to compensate for this, they resort to increasing longer-term interest rates. Thus, changes in the overnight lending costs indirectly influence bank rates on savings accounts and debt instruments, such as mortgages and lines of credit. This in turn impacts money supply, leading to variations in the broader inflation rate.
Reasons for maintaining the status quo
The bank cited limited upside risk to inflation and moderate growth as reasons for maintaining the status quo. The central bank sees higher crude prices and a slow rate in wage hikes as having a transitory impact on headline inflation in the short-term. Over the medium-term, however, inflation is expected to remain close to 2 percent, which is also the projected target for the central bank. Also, Canada has witnessed a slowdown in growth numbers in the second quarter of this year, after reporting strong growth numbers of around 3.0 to 3.5 percent in the second and third quarters of 2017 respectively. This moderation in growth to 1.3 percent has been due to a moderation in the real-estate market, which is adjusting to the new federal mortgage rules and changes in housing policies. Also, the country’s exports have taken a hit due to transportation bottlenecks.
While acknowledging that global economic activity remained broadly on track, the central bank expressed concerns over ongoing uncertainty in trade policies, especially with the United States, which is hampering global business investment and developing cracks in some of the emerging-market economies. The uncertainty arises from renegotiating the NAFTA (North American Free Trade Agreement), and there are fears over competitiveness due to corporate tax cuts in the US. In addition, US President Donald Trump’s tariffs on steel and aluminum imports continue to weigh on concerns related to the global trade policy.
The central bank expects the Canadian economy to rebound in 2018, with GDP (gross domestic product) growth expected to rise to 2.5 percent, mainly due to increasing foreign demand. Also, recent data from the United States points to continued growth, and the outlook remains positive in the US going ahead, which will enable Canada’s economy to expand by 2.0 percent for the rest of the current financial year. The bank also expects growth to pick up on account of increased housing activity and consumption due to a strong labor market. The BoC concluded that overall developments indicate that higher interest rates will be warranted in the future to keep inflation at bay, thereby maintaining a hawkish tone. The tone of the policymakers indicate that they have kept the door wide open for a rate hike in the July meeting, assuming that there is no significant pressure on trade relations between the US and Canada and the global economic outlook continues to forge ahead.
The overnight policy interest rate is the key reference rate used by the central bank to influence the money supply in the Canadian economy. The central bank in its May meeting kept the policy rate unchanged at 1.25 percent amid a backdrop of moderation in growth and headline inflation. The moderate growth is a consequence of uncertainty in trade policies and temporary adjustments to policy changes in the housing sector. The strong labor market will, however, lead to a pick-up in economic growth and inflation going forward, indicating a possible rate hike during the next meeting, which is scheduled for July 11.