Saving room to go lower: The Bank of Canada holds rates steady

January 23, 2020 Wesley Blight

The Bank of Canada announced that it will maintain its target overnight rate at 1.75% for the coming weeks. It says the global economy is showing signs of stabilization and recent trade developments have been positive, but there remains a high degree of uncertainty in the global economy, thanks to re-emerging geopolitical tensions.

This announcement, a rather dovish stance for the bank, leaves interest rates unchanged, but investor reaction and the Bank's own tone both suggest that future policy decisions will result in lower rates.

In its announcement the Bank refrained from using language that previously suggested that the current policy rate is appropriate. Investors reacting to the news caused Canadian bond yields to fall across the curve on Wednesday morning. The Canadian dollar also fell relative to the U.S. dollar.

Mixed bag of signals in Canada

In Canada, the Bank says the economy has been resilient, but indicators are mixed. The Bank adds that growth in the near term will likely be weaker; it estimates growth of just 0.3% in the fourth quarter of 2019 (previously predicted to be 1.3% back in October) and 1.3% in the first quarter of 2020.

That said, it is important to note that the Bank of Canada will largely ignore near-term weakness, as policy decisions take time to have their desired impact. In addition, it is worth noting that the fourth quarter slowdown was caused in part by temporary factors including labour strikes and weather conditions.

Overall, exports and business investment—both influenced by geopolitics and global trade—both weakened following a strong third quarter in 2019. Job creation also slowed and consumer confidence and spending have been unexpectedly soft. In contrast, residential investment was robust through most of 2019, moderating to a still-solid pace in the fourth quarter.

“The weaker data could signal that global economic conditions have been affecting Canada's economy to a greater extent than was predicted," the Bank writes in its announcement. “Canadians have also been saving a larger share of their incomes, which could signal increased consumer caution." The Bank is projecting a pickup in household spending in the coming months. Business investment, industrial production and exports, meanwhile, are expected to contribute modestly to growth going forward.

The Bank predicts slowly improving growth going forward

Following 1.6% real GDP growth in 2019, the Bank is now calling for growth of 1.6% in 2020 and 2% in 2021. Inflation is expected to stay around 2%, with some fluctuations from volatile energy prices. Going forward, the Bank says it will be watching closely to see if the recent slowdown is more persistent than originally expected. It will also be paying particular attention to developments in consumer spending, the housing market and business investment.

From the latest Monetary Policy Report (MPR), “the Bank anticipates that economic activity will improve through 2020 and grow just above the rate of potential in 2021. Household spending is expected to strengthen and grow at a moderate pace. The contribution to growth from business investment and exports should also increase as foreign demand improves, the impact from trade policy uncertainty diminishes and oil capacity expands." Growth in government spending, meanwhile, is expected to slow.

The overall output gap (difference between actual output and maximum potential output) widened in the fourth quarter, thanks to weaker than expected growth. Potential output is assumed to average 2% over 2019 and 2020, before edging down to 1.8% in 2021. Although these rates are higher than the midpoint of the Bank's estimated ranges, and stronger than anticipated in the October MPR, the numbers are still weak. With low potential output, it does not take a lot of economic growth to push inflation numbers up. This has supported the Bank's recent ability to meet their inflation targets. It is also partially why the Bank has not decreased their policy rate this month.

Overall, the Bank of Canada still has the highest rate across major developed countries. If actual growth isn't poised to recover from recent weakness, there is clearly room to lower rates.

As the Bank's outlook is broadly inline with our own expectations, we do not anticipate any material changes to our positioning at this time as a result of Wednesday's rate announcement. With that being said, please don't hesitate to reach out to your MD Advisor* with any questions you may have.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

About the Author

Wesley Blight

Wesley Blight, CFA, CIM, FCSI, is an Assistant Vice President with the Multi-Asset Management team at MD Financial Management. He is responsible for the investment results of the firm’s fixed income and multi-asset products.

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