BoC hikes interest rate to 1.25% on strong economic data

The Bank of Canada (BoC) today raised its target for the overnight rate to 1.25%, an increase of a quarter of a percentage point. The bank rate is correspondingly 1.50%, and the deposit rate is 1.00%.

The change is expected to prompt Canada’s large banks to raise their prime lending rates, a move that will drive up the cost of variable-rate mortgages and other variable-interest rate loans.

The economy’s impressive run prompted the BoC to raise its trend-setting interest rate for the third time since last summer. In a press release, the central bank said recent data have been strong, inflation is close to target and the economy is operating at roughly capacity.

“Consumption and residential investment have been stronger than anticipated, reflecting strong employment growth,” the release said. “Business investment has been increasing at a solid pace, and investment intentions remain positive.”

Moving forward, the BoC predicts household spending and investment to gradually contribute less to economic growth, given higher interest rates and stricter mortgage rules. It predicted Canada’s high levels of household debt would amplify the effects of higher interest rates on consumption.

Read: Rising rates have Canadians worried about paying bills

NAFTA was cited as another economic risk, which the BoC says it has incorporated into its economic projection, with a negative judgment on business investment and trade.

Economic projections

The central bank said the global economy continues to strengthen, with growth expected to average 3.5% over 2017-2019, with growth in advanced economies stronger than in the bank’s last monetary policy report (MPR)—particularly for the U.S., which will see growth boosted by recent tax changes.

Read: Canada, U.S. won’t drive global growth over next two years: Scotiabank

For Canada in 2017, the BoC now predicts 3% growth in GDP, compared with its 3.1% prediction in October.

The bank slightly increased its predictions for Canadian GDP in 2018, up to 2.2% from 2.1%. It expects the economy to expand by 1.6% in 2019, up from its previous call of 1.5%.

The fourth quarter of 2017 and the first quarter of 2018 are each expected to see annualized growth of 2.5%.

The BoC also said governor Stephen Poloz’s team is closely watching the economy’s ability to grow without driving up inflation.

“In this respect, capital investment, firm creation, labour force participation and hours worked are all showing promising signs,” the BoC said.

CPI inflation is estimated to have averaged 1.8% in the fourth quarter of 2017.

“Temporary factors, such as past electricity rebates, below-average food price inflation and exchange rate pass-through have contributed to keep inflation below target in recent quarters,” says the bank in its MPR.

The BoC expects inflation to ease this month reflecting transitory effects of elevated gas prices a year earlier. Inflation is expected to rise later in the year, “as the temporary effects of past fluctuations in consumer energy and food prices fade.” Overall, inflation is expected to remain close to 2%.

Compared with the last MPR in October, higher prices for crude oil are expected to lift the inflation profile in 2018, but other sources of inflationary pressures remain broadly similar. The inflation projection also incorporates the estimated effects of recent and scheduled increases in provincial minimum wages.

Again referring to NAFTA, the bank said the most important risk to its inflation outlook is the shift toward protectionist global trade policies.

Next rate decision

Heading into the decision Wednesday, Scotiabank Economics forecasted three hikes totalling 75 basis points throughout 2018 and three more in 2019. TD Economics expected a gradual pace of tightening over the next two years of about 25 basis points every six months.

The Bank of Canada stressed that it would remain data dependent when mulling future rate decisions. The next announcement is scheduled for March 7.

“Governing council will remain cautious in considering future policy adjustments, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity and the dynamics of both wage growth and inflation,” the bank said.

In its MPR, the bank notes that financial conditions remain accommodative.

“Even with recent interest rate increases, the stance of monetary policy in Canada remains accommodative and continues to support the level of economic activity,” says the report.

In an email to clients, CIBC chief economist Avery Shenfeld said that the BoC “put NAFTA uncertainties right up front in their statement, and also explained that monetary accommodation (i.e., rates at stimulative levels) will be needed to reach their growth and inflation forecasts, reasserting the need to be cautious in how fast they hike ahead.”

He describes today’s statement as dovish “relative to the minimum degree of optimism needed to justify a rate hike today, and could put some downward pressure on two-year yields and the value of the C$.”

He forecasts one further hike this year, likely in Q3, and a further increase of 50 basis points in 2019.

Read: Get ready for more volatility

Read the BoC’s full monetary policy report released today.