Bank of Canada Identifies Two-Sided Interest Rate Policy Risk

January 22, 2014

For the first time since the last overnight interest rate policy change — a 25-basis point hike to 1.0% in September 2010 — Bank of Canada officials allowed for the possibility that the next change could be a cut.  The subtle warning is contained in the final sentence of today’s rate announcement: “The timing and direction of the next change to the policy rate will depend on how new information influences this balance of [price] risks.”   Always before this, forward guidance had been framed as a choice between no change or a rate hike.  The probabilities of those options had shifted from time to time, but only now has the risk of a rate cut been introduced.

The Bank of Canada’s inflation target is 2.0%, and today’s statement begins with a mea culpa that inflation has moved further below that goal, albeit unintentionally, and a forecast that inflation will stay under target through end-2015.  Projected on-year core inflation has been revised downward for every quarter from 4Q13 through 4Q15, and the same has been done for on-year total inflation for each quarter from 4Q13 through 1Q15. 

These changes were not made because of a reassessment of economic growth.  Real GDP is projected to expand at 2.5% in both 2014 and 2015, more or less in line with the 2H13 pace, and the statement speaks bullishly about U.S. growth prospects, which is a positive development for Canada’s outlook.  Canada has experienced more disinflation than anticipated rather because of fiercer retail competition and the persistence of an output gap, that is excess product supply. 

Reading between the lines, there seems to be a hidden trade-off.  The policy statement identifies “recent depreciation of the Canadian dollar” as a very positive development for the outlook for exports, business confidence and investment.  If the C-dollar keeps retreating or at least doesn’t reverse recent losses, it seems that the next policy change will be a rate hike, although such may occur later than implied before.  If the exchange rate instead remains excessively overvalued, the odds clearly rise that the de facto tightening of monetary conditions from such may be offset with a rate cut.  Officials are clearly worried that the length of time that inflation has been below target means that downside risks to future inflation must be taken more seriously.

The second policy announcement of 2014 is scheduled for March 5.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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