More rate hikes to come?

Analysts are divided over whether Bank of Canada governor David Dodge will announce another interest rate hike on Tuesday. Following the bank’s last announcement in May, all signs suggested that the bank was done hiking rates. Surprise employment and core inflation numbers, however, may well have upset those odds.

Economists Marc Levesque of TD Securities, Avery Shenfeld of CIBC World Markets and RBC’s Rishi Sondhi each weighed in on the issue in separate reports discussing factors that have changed since the central bank’s last rate increase in May.

Levesque says markets are already pricing in one more rate hike. Although not all of the economic data available is strong — exports and manufacturing shipments are soft, recent export data was “surprisingly weak” and GDP growth numbers are somewhat lacklustre, he says employment data and the most recent inflation figures may have changed perceptions about both capacity constraints and inflation pressures.

On the employment front, both service and private sector paid employment numbers show the fastest two-month pace of job creation on record, and overall unemployment has dropped in recent months. As well, the CPI jumped in May to 2%, up from 1.6% in the previous month.

“Unless that reverses itself in the next release — and there is no reason to expect it to — it looks as if the Bank of Canada is dealing with an economy operating at full capacity according to its output gap measure, a labour market that is unquestionably tight, wage growth that is picking up and inflation that is on, not below target,” says Levesque.

“All in all, this is going to be a very close call for the Bank of Canada,” he adds. “While it could go either way, we would bet on a hike. The odds now appear to be ever so slightly tilted towards the Bank of Canada tightening the monetary screws again.”

Over at CIBC, Shenfeld agrees on a number of points, but points out that, employment aside, the economy doesn’t look much different than the projection Dodge was using when he judged that a steady 4.25% rate would put the economy on the 2% inflation track outlined in the bank’s April Monetary Policy Report.

“If Bank of Canada Governor Dodge wants to have markets take him at his word, he would be inclined to pass on the chance to raise interest rates, having all but promised that rates would be on hold for a while after the last hike,” says Shenfeld. “But he also has his reputation as an inflation targeting central banker to maintain. The latest up tick in core CPI to the 2% target would appear to lean towards another rate increase.”

Despite this, Shenfeld predicts the bank will make only minor revisions to its outlook and should be willing to abide by its earlier assessment that a 4.25% overnight rate is already high enough to contain inflation. “The only catch for financial markets might be a change in the wording that makes the pledge to stay on hold a bit less definitive,” he says

As for RBC’s Sondhi, he says the combination of stronger-than-expected economic reports and a rise in the core inflation rate keeps the odds that the Bank of Canada will increase the overnight rate by another 25 basis points relatively high. “Our view is that the bank will want ensure that price pressures do not accelerate or break out of the 1% to 3% target band over the medium-term. We believe that if the bank were to ignore these reports and keep the policy rate unchanged, it would raise upside risks to their medium-term inflation target.”

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com