Bank of Canada keeps its foot on the gas, but hints at changes to come

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Canada’s central bank is getting ready to take its foot off the gas, but it intends to proceed at full throttle for now.

The Bank of Canada acknowledged it had underestimated the economy’s ability to power through the second wave of COVID-19 infections, scrapping its January prediction that gross domestic product (GDP) would contract in the first quarter of 2021.

“Consumers and businesses are adapting to containment measures, and housing market activity has been much stronger than expected,” the central bank said in an updated policy statement on March 10. “Improving foreign demand and higher commodity prices have also brightened the prospects for exports and business investment.”

Indeed. GDP jumped to an annual rate of 9.6 per cent in the fourth quarter, forcing Bay Street economists to upgrade their outlooks for 2021. Commodity prices have surged along with the global recovery, allowing Canada to record a rare trade surplus in January — and the widest one since July 2014. The real-estate market is so hot that Bank of Canada governor Tiff Macklem last month said he was starting to see early signs of “excess exuberance.”

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Still, the hole left by the COVID-19 crisis is immense and the climb out will be long. The Bank of Canada reiterated that it currently intends to keep the benchmark interest rate at 0.25 per cent until sometime in 2023, and that it will continue to create money to purchase at least $4-billion worth of Government of Canada bonds each week “until the recovery is well underway.”

Policy-makers observed that the labour market is “a long way from recovery,” and they said the spread of COVID-19 variants represents a significant threat. There was speculation on Bay Street that the central bank would clearly state its intention to taper its bond purchases, but the central bank isn’t ready to make such a hard pivot. Things could still take a turn for the worse.

“We don’t get the bullishness around the Canadian economy versus the U.S. economy,” said Tom O’Gorman, director of fixed income at Franklin Templeton Canada. “It just doesn’t make sense when one economy (Canada) is based on residential housing and latent consumer consumption, versus the U.S., where you are way ahead with vaccines.”

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Canada will benefit from the U.S. recovery, of course. President Joe Biden’s US$1.9-trillion stimulus package, which cleared Congress on March 10, will increase economic output in Canada and Mexico by between 0.5 and one percentage point, the Organisation for Economic Co-operation and Development (OECD) said in a revised forecast this week.

The OECD sees Canada’s GDP expanding 4.7 per cent this year, a 1.2-percentage-point increase from its previous outlook in December. That would only partially make up for 2020’s historic 5.4-per-cent drop, which explains why the central bank is inclined to let the economy run hot until inflation becomes a significant problem.

Macklem and his deputies on the Governing Council mostly brushed aside worries about inflation. They attributed the recent jump in bond yields to repricing related to the “improved U.S. growth outlook.”

They observed that inflation, as measured by the Consumer Price Index, is on the low side of their comfort zone, adding they expect economic weakness will continue to exert downward pressure on prices for a while yet. They are also betting that a strong recovery leads to new capacity that will absorb increased demand.

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“A more resilient Canadian economy implies less scarring from the pandemic, which suggests growth can be stronger without becoming inflationary,” Sri Thanabalasingam, an economist at Toronto-Dominion Bank, said in a research note. “This offers room for the bank to maintain monetary stimulus at its current level.”

To be sure, the Bank of Canada is keeping an eye on the economic dashboard, where more and more indicators are coming up positive. Policy-makers reiterated that their pledge to keep the benchmark rate near zero until 2023 is based on their outlook in January, which is now outdated. A continued run of strong numbers could force a tweak to the timing of higher interest rates.

Macklem and his deputies also re-upped a hint that they could be getting closer to tapering their asset purchases, which will probably precede an interest-rate increase. “As the Governing Council continues to gain confidence in the strength of the recovery, the pace of net purchases of Government of Canada bonds will be adjusted as required,” they said.

The central bank now expects growth in the first quarter, rather than a contraction, so it is clearly gaining confidence in the recovery. Policy-makers next meet to discuss interest rates in April. If current trends continue, a policy adjustment could occur then.

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