To raise or not to raise rates? What the BoC must consider

Speculation on the next move by the Bank of Canada (BoC) suggests a rate hike is possible due to strong economic data.

Read: Hike gave Fed “more breathing room,” says analyst

In an economics viewpoint report, Desjardins senior economist Jimmy Jean notes that last year Canadian growth surpassed that of the U.S., except in Q2, which was affected by the forest fires in Alberta.

And, in an economics note, James Marple, senior economist at TD Bank, says the rebound in growth is mainly the result of a recovery in the oil patch. TD expects that recovery to continue in 2017, along with growth from the construction sector, thanks in part to residential real estate activity.

Job creation has also been strong, with the six-month average of job creation reaching 40,000 in January, an unprecedented level since the financial crisis. And the unemployment rate (6.6%) is the lowest since the crisis. Further, inflation measures aren’t far below target.

“If the output gap tightens faster than expected, [inflation] measures could well converge toward the 2% target in the not too distant future,” says Jean.

But the real estate market represents an economic risk. Referencing Toronto’s hot market, Jean says there may be macro-prudential tools announced by the provincial government to cool things on that front.

Read: Toronto homes prove too pricey for top 1%

Though the BoC prefers real estate risk to be addressed by those types of measures rather than by monetary policy, the strong economic developments could mean “the death knell of the easing bias that appeared in October and was reaffirmed in January,” says Jean.

A case to keep rates steady

Despite the strong economic indicators, there are also some contrary ones, like the weakness in hours worked in Canada. Though hours improved in February, the pace of -0.3% year-over-year disappoints. Hours worked are important because they are the measure of labour input used in many conventional models, explains Jean.

Private investment is also low, with cuts in investment budgets for the energy sector accounting for much of the decline the last two years. Only 35% of sectors intend to increase investment in 2017, compared to about half of sectors over the last two years. Though public investment will help offset weakness, that might not be enough.

“The sustainable growth idealized by the BoC implies an enhanced contribution from private investment and a simultaneous moderation of the contributions from households and real estate,” says Jean. “Success still seems a long way off on this front.”

In addition, real exports increased in only two of the five months to February. Though the Canadian dollar appreciated against most currencies last year, that trend has reversed since January.

The biggest concern for exports remains potential U.S. protectionism.

Says Jean: “A border adjustment tax as outlined by the Republicans would severely hamper the competitiveness of Canadian exporters. This would come on top of the erosion in tax competitiveness for Canadian companies, with the reforms that are on the horizon in Washington. A significant depreciation of the currency would be required to mitigate all these effects.”

Given the Bank’s desire to support rotation toward exports, which relies on a competitive exchange rate, Marple expects the Bank to remain on hold well into 2018.

Read: Potential growing pains for Canada’s economy

Jean says the positive indicators support a possible change in tone when governor Poloz delivers his next speech on March 28, but, given the trade policy risks, easing may be a possibility after all .

Read the full Desjardins report here.

Read the TD report here.