Although it says higher interest rates will eventually be required, the Bank of Canada announced Wednesday that it is holding its overnight lending rate steady at 1.25%.
The announcement and the Bank’s most recent Monetary Policy Report point to weaker than expected growth in Canada during the first half of 2018, the result of poor household spending and slow export activity. Although GDP growth was weaker than the Bank had expected, it says growth should rebound in the second quarter, resulting in 2% average growth overall for the first half of the year.
The Bank anticipates that short-term weakness for housing activity will recover as the market adjusts to mortgage regulation changes. Net exports are also expected to improve in the second half of the year as transportation issues are resolved and as export demand increases. That said, heightened uncertainty surrounding trade polices (the North American Free Trade Agreement among them) continues to cloud the outlook.
Even without changes to trade arrangements, the Bank says increased concerns about trade policies could lead to a sharper-than-expected tightening of financial conditions, lower confidence and a more pronounced slowing of growth.
Beyond 2018, the Bank expects Canada’s economy to expand at a pace above capacity before real GDP growth slows to 1.8% in 2020. At the same time, inflation is expected to rise above 2% before coming back to the Bank’s target inflation rate. This expectation underpins the Bank’s announcement that higher interest rates will be warranted over time.
The heavily indebted Canadian consumer’s ability to absorb higher carrying costs will continue to be a focus for policy makers contemplating future rate increases as well: The Bank says the pace of expansion of household credit has slowed since last summer, indicating that higher interest rates and measures affecting the housing market are beginning to have an impact on borrowing behavior.
Higher interest rates and slowing growth in disposable income is also expected to gradually dampen household spending growth over time. Between now and 2020, GDP growth composition is expected to shift, with a declining contribution from household spending and a rising relative contribution from business investment and exports.
Although our fixed income funds and pools are actively positioned for modestly higher interest rates, we are looking for signs of sustainable economic expansion in Canada—wage inflation, improving net exports and business investment—before making additional adjustments in preparation of more material interest rate increases.