BoC sounds bullish as key rate hiked to 0.75%

The BoC raised its Canadian growth forecast on Wednesday as it lifted its overnight rate target to 0.75% — the first hike in almost seven years.

In a release, the bank says it is confident in its outlook for “above-potential” growth and the absorption of excess capacity in the economy. Though inflation is soft, the BoC deems that a temporary situation, attributable to factors such as technological advances.

“If lower inflation reflects increased global potential and heightened competition, it suggests higher living standards rather than signalling economic weakness,” says the central bank in its monetary policy report.

And, because there’s a lag between monetary policy actions and future inflation, the BoC says its timing is appropriate. With the 25 basis point rate hike, the bank rate is correspondingly 1% and the deposit rate is 0.5%.

Investor reaction

Though the bank is warding off future inflation with the hike, Avery Shenfeld, managing director and chief economist at CIBC Capital Markets, says in an industry note that the hike aligns with government policies aimed at cooling mortgage activity that’s not needed to sustain job gains.

Allan Small, senior investment advisor at Allan Small Financial Group, says it’s time for investors to monitor rate-sensitive investments like REITs, and conservative dividend players like utilities and telecoms. Sectors like financials and technology do better in a rising-rate environment.

But things won’t necessarily change in the near-term, he says. Investors should stay in the market and diversify, as always, while hedging for interest rate risk, geography risk and currency risk.

Strong Canadian growth

For the Canadian economy, near-term growth is expected to remain solidly above potential, with the BoC projecting a 3.0% annualized growth rate for Q2 2017 — up from the 2.5% forecast in April’s monetary policy report. Growth is broadening across industries and regions and therefore becoming more sustainable, the BoC says.

Household spending will likely remain solid in the months ahead, supported by rising employment and wages, and exports are expected to make an increasing contribution to GDP growth. Business investment should also add to growth, a view supported by the most recent business outlook survey.

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Over its projection horizon, the bank estimates real GDP growth to moderate from 2.8% in 2017 to 2% in 2018 and 1.6% in 2019. The economy is now projected to reach full potential around the end of 2017, earlier than the bank anticipated in its last monetary policy report, when it had forecasted the first half of 2018.

As excess capacity is absorbed, and as relative price movements in food, electricity and cars dissipate, the bank expects inflation to return to 2% in the middle of 2018.

Growth outlook and financial markets

The BoC says the recent increase in yields on long-term sovereign bonds is driven by stronger global growth and market expectations of less accommodative monetary policy in advanced economies, including the reduction of the Fed’s balance sheet expected to begin later this year. Global credit spreads remain near post-crisis lows, and equity prices are close to past highs. Further, the U.S. dollar has seen a modest depreciation.

Read: Expect rate hikes and unwinding of balance sheet: Yellen

The central bank’s view of U.S. growth for 2017 remains stable at 2.2%, while greater growth is expected in the euro area (1.9% versus its previous forecast of 1.6%), based on recent economic indicators. The pace of expansion in oil-exporting emerging market countries is projected to rise to 4.0% (up from the previous projection of 3.7%) as the impact of declining oil prices eases and emerging markets recover from recession and make progress on economic reforms.

Read: Two tips for assessing emerging markets

What’s next

The next scheduled date for announcing the overnight rate target is September 6, 2017.

Read: Don’t try to predict long-term rates

Shenfeld notes that the bank offered no hint about the next hike, saying only that it depends on the data. But he leans toward October. “By skipping September,” he says, “the bank can signal that this will be a gradual process.”

Josh Nye, economist at RBC Capital markets, agrees. In an industry note, he adds that the bank didn’t necessarily frame today’s hike as simply reversing the rate cuts of 2015.

“Rather, we think the bank’s projection that economic slack will be fully absorbed by the end of 2017 raises the risk that policy-makers do more than withdraw those 50 basis points of ‘insurance cuts’ over the next year,” he says.

Brian DePratto, senior economist at TD Bank highlights in an industry note statements made by Governor Poloz at a press conference after the hike was announced. Poloz said the hike can’t be categorized as either removing 2015 stimulus or striving to normalize interest rates.

Says DePratto: “As such, we believe that another rate hike is likely at the Bank of Canada’s October monetary policy decision, but a slightly slower pace of one 25-bp hike every six months or so is likely thereafter.”

At the press conference, Poloz said: “In the full course of time, I don’t doubt that interest rates will move higher, but there’s no predetermined path.”