Bank of Canada holdsovernight rate at 1.00%; statement provides hedge against inflation remainingbelow target

(January 22, 2014 )


·          The Bank of Canada left the overnight rate unchanged at 1.00% as expected.·          The Bank says monitoring data to determine “timing and direction of the next change to the policy rate.” ·          It reiterated that overall balance of risks in same “zone” as October.·          Today’s statement, while on the margin more upbeat on the growth outlook than in previous months, hammered home the Bank’s concerns about inflation remaining below target for a sustained period and the risks that this underperformance will continue. Our forecast for Canada’s economy in 2014 is for growth to accelerate to a 2.6% pace with both the export sector and investment activity picking up. By our estimate, the output gap will be eliminated in the second half of 2015; at which time, the inflation rate will be within reach of the Bank’s 2.0% target. Against this backdrop, we see little need for the Bank to lower the overnight rate, and while we expect the next move will be a hike, no changes are on tap for 2014. As expected, the Bank of Canada held the policy rate at 1.0%. The statement focused on the low starting point of inflation and indicated that the Bank had reduced the projection path for both the headline and core measures. Furthermore, the Bank emphasized the downside risks to the inflation outlook resulting in the tweaking of its outlook statement such that there is scope for rates to move higher or lower depending on how data play out. With that said, the Bank upped its forecasts for global and Canadian growth in 2014. The statement highlighted the Bank’s disappointment with the weak recovery in the export sector to date. Backed by a stronger outlook for the US and global economy, and weaker Canadian dollar, the Bank upgraded its forecast for export activity in 2014 and boosted the contribution to real GDP growth to 0.6 percentage points from 0.3 percentage points contained in the October 2013 forecast. Against a stronger forecast for global growth, the Bank boosted its growth projection for Canada’s economy in 2014 to 2.5% from 2.3% while inching down the 2015 forecast to 2.5% from 2.6%. The Bank expects that the pace of growth will be sufficient to eliminate the output gap during the next two years. The base case has the headline inflation rate at 2.0% in the fourth quarter of 2015 although the core rate ends that year at 1.9%. The Bank of Canada’s statement indicated that policymakers view the maintenance of a 1% overnight rate as the best course to balance the downside risks to the inflation outlook with upside risks being generated from keeping interest rates at very low levels. With that said, today’s statement put greater emphasis on the downside risks to inflation and in particular raised concerns about the uncertainty embedded in the inflation forecasts in the context of the recent downside surprises in the inflation data and currently very low levels of both the headline and core rates. The improvement in the global, and in particular US, outlook lays the groundwork for stronger Canadian growth in 2014 backed by an upgraded forecast for net exports. The Bank acknowledged that the US economy grew at a faster than projected clip in the second half of 2013 and is likely to maintain improved momentum in 2014. Our view is that the improvement in the US will result in the long-awaited strengthening in demand for Canadian exports with the sharp weakening in Canada’s dollar against the US dollar, thereby providing additional support. Increased demand for exports will be a key factor in boosting the economy’s growth rate above its potential in 2014. Additionally, we expect this will bolster business confidence and result in an increase in investment activity. While the Bank of Canada is also looking for this to occur, no change was made to the projected support coming from this sector in 2014 in its forecast update. In the Bank’s Winter Business Outlook Survey, firms in the goods producing sector in particular cited that uncertainty about domestic demand was holding them back from making investments. To the extent that businesses increase production to meet rising export demand, conditions in the domestic economy will improve supporting increased investment activity. The survey also indicated that companies with sales outside of Canada experienced an increase in sales volumes in the past year. The Bank’s updated forecast did not materially change the estimate of the timing of the closure of the output gap and correspondingly when the headline inflation rate is forecasted to return to the 2% target (year-end 2015). Today’s statement, while on the margin more upbeat on the growth outlook than in previous months, hammered home the Bank’s concerns about inflation remaining below target for a sustained period and risks that underperformance will continue. Our forecast for Canada’s economy in 2014 is for growth to accelerate to a 2.6% pace with both the export sector and investment activity picking up. By our estimate, the output gap will be eliminated in the second half of 2015; at which time, the inflation rate will be within reach of the Bank’s 2.0% target. Against this backdrop, we see little need for the Bank to lower the overnight rate, and while we expect the next move will be a hike, no changes are on tap for 2014.