The Bank of Canada raised its benchmark interest rate Wednesday in an economy that it predicts will remain resilient even as it faces a bigger bite from deepening trade tensions.
The rate hike was the central bank’s first interest rate move in six months and lifted the trend-setting rate to 1.5%, up from 1.25%. It was the bank’s fourth rate increase over the last 12 months.
The decision, a move that will likely prompt Canada’s big banks to raise their prime rates, arrived in the middle of a trade dispute between Canada and the United States that’s expected to hurt both economies.
The bank took the step even as it predicts larger impacts from the widening trade uncertainty, particularly after the United States imposed steel and aluminum tariffs on Canada and after Ottawa’s retaliatory measures. The tariff fight, the bank estimated, will shave nearly 0.7% from Canada’s economic growth by the end of 2020.
However, the bank expects the negative blow of the trade policies recently put in place to be largely offset by the positives for Canada from higher oil prices and the stronger U.S. economy.
“Although there will be difficult adjustments for some industries and their workers, the effect of these measures on Canadian growth and inflation is expected to be modest,” the bank said in a statement.
But in addition to steel and aluminum tariffs, Canada is facing a significant trade-related unknown that many believe would inflict far more damage on the economy: U.S. duties on the automotive sector.
U.S. tariffs on the auto sector’s integrated cross-border supply chains would have “large impacts on investment and employment,” the Bank of Canada warned Wednesday in its accompanying monetary policy report.
The bank, however, didn’t quantify the possible effects of auto tariffs on Wednesday. Governor Stephen Poloz has signalled in the past that he’s focused on data he can measure rather than the impacts of trade policies that have yet to materialize.
Canadian businesses must also contend with the uncertainty surrounding the difficult renegotiation of the North American Free Trade Agreement, for which talks have stalled.
The Bank of Canada also has its eye on how widening global trade disputes, including an intensifying battle between the U.S. and China, will affect the world’s economy. It warns that “escalating trade tensions pose considerable risks to the outlook” at the global level.
Growth projections stay steady
Despite trade concerns, the bank expects real gross domestic product to grow 2.2% in 2019, up a tick from its April call of 2.1%, and by 1.9% in 2020, compared with its previous prediction of 1.8%. The economy’s growth projection for this year remains at 2%, the bank said.
Looking ahead, the bank predicts Canadian growth will continue to see bigger contributions from exports and business investment, which were both stronger than expected in the first three months of the year.
At the same time, household spending will represent a smaller and smaller share of overall growth due to the dampening effects of higher interest rates and stricter mortgage rules, it said.
As part of its global outlook, the bank cited such things as diverging monetary policies from global central banks and higher bond yields—a reflection of actual and expected monetary policy changes. It also noted that the positive outlook for the U.S. economy has contributed to an appreciating U.S. dollar, as well as to portfolio outflows from emerging-market economies—a development that exacerbates country-specific vulnerabilities. The bank also noted volatility in equities because of trade concerns.
Despite such changes, “global financial conditions are supportive of economic activity” overall, said the bank in the monetary policy report. The bank expects the global economy to grow by about 3.75% in 2018 and 3.5% in 2019, in line with April’s monetary policy report.
Monetary policy analysis
Leading up to the announcement Wednesday, Poloz was widely expected to raise the interest rate following a run of healthy economic numbers, including the Bank of Canada’s own survey on business sentiment, tightened job markets and growth in wages.
Moving forward, the bank said it expects higher interest rates will be necessary over time to keep inflation near its target; however, it intends to continue along a gradual, data-dependent approach.
The country’s inflation rate is expected to rise to 2.5%—above the 2% mid-point of the bank’s target range—due to temporary factors such as higher gasoline prices before settling back down to 2% in the second half of 2019.
In emailed commentary, CIBC chief economist Avery Shenfeld said today’s growth forecasts were “nothing much new,” and were in line with the central bank’s upgraded view on the economy’s non-inflationary potential.
“Overall, with the statement retaining the call for gradually higher interest rates ahead, guided by upcoming data, there isn’t anything surprising to us in the message,” wrote Shenfeld.
As for market effects, today’s announcement could take the loonie and short-term bond yields “a touch higher,” he added.
The next scheduled date for announcing the benchmark rate is Sept. 5, 2018.