Bank of Canada Maintains 0.75% Overnight Interest Rate Target and Released New Monetary Policy Report

April 15, 2015

In conjunction with the previous quarterly full review, the interest rate had been cut by 25 basis point to 0.75%.  That was the first rate change, up or down, since a hike of 25 basis points in September 2010.  A subsequent Governing Council meeting on March 4 retained the 0.75% target along with a 1.0% Bank Rate and a deposit rate of 0.5%, and so has this week’s meeting and decision after which a new Monetary Policy Report with important differences from the January Report got released.

The changes since January in the central bank’s view about the evolution of growth and price inflation in Canada are several and offsetting such that a 0.75% target interest rate remains appropriate.  This quote from Governor Poloz presents some modifications from the prior view, namely no economic growth last quarter versus a prior expectation of a positive growth quarter.

Purchases are intended to run until the end of September 2016 and, in any case, until we see a sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term. When carrying out its assessment, the Governing Council will follow its monetary policy strategy and concentrate on trends in inflation, looking through unexpected outcomes in measured inflation in either direction if judged to be transient and to have no implication for the medium-term outlook for price stability.

As a result of the more front-loaded drag hitting Canada’s energy sector but greater and more lagged boosts to non-energy exports and investment caused by C-dollar depreciation, looser financial market conditions, and improving U.S. demand, the output gap, which measures evolution in the difference between potential and actual GDP, is projected at 0.5% to 1.5% during the first quarter of 2015.  This is greater than the previous estimate.  However, output gap is now expected to narrow starting in the present quarter more quickly than imagined before and to disappear by the end of 2016, which is similar to the previous predicted return to full employment of productive resources. 

So long as actual GDP lies below the theoretical full employment level of GDP, the impact on inflation from demand-side factors is downward, but officials do  expect core inflation to barely fall in coming quarters.  Such is projected to average 2.1% this year, 2.05% in 2016 and at the targeted 2.0% in 2017.  For one thing, depreciation in the Canadian dollar is augmenting core inflation by some 0.3-0.4 percentage points.  For another, a recovery in Canadian GDP growth is anticipated.  In contrast to likely zero economic growth last quarter, the new Monetary Policy Report predicts GDP rising at a 1.8% annualized rate in the current quarter followed by 2.8% in 3Q, 2.5% in each of the ensuing three quarters through mid-2016,2.2% in the second half of 2016, 2.0% in 1Q17, 1.9% in 2Q17 and 1.8% thereafter.  1.8% also happens to be the assumed growth in potential GDP.

In sum, the new forecast conveniently depicts a return to above-trend economic growth that gradually reduces the output gap.  While the output gap exists, other factors like C-dollar depreciation keep core inflation, which is already hovering just above target from rising further so.  The base effect of removing plunging energy prices as a factor allows total CPI inflation to converge on the 2.0% inflation target by the start of 2016, and after 2016 when full employment is attained, actual GDP has slowed to the 1.8% rate of potential growth.  This is a complicated process.  Several unrelated elements have to exactly as assumed for the output gap to follow its assumed benign trajectory, leaving all sorts of ways for the path to instead veer off the assumed course.  A key variable remains the Canadian dollar’s external value, which interestingly has now fallen very near to what is consistent with the exchange rate’s historical relationship with oil prices.  However, there will be a lot of lead time for mid-course corrections, and officials have done the prudent thing at this juncture in adopting a trust and verify approach.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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