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Canada Monetary Policy January 2018

Canada: Bank of Canada hikes rate to 1.25% but signals caution due to NAFTA

On 17 January, the Bank of Canada (BoC) raised its target for the overnight rate by 25 basis points to 1.25%, in a decision that was widely expected by market participants. This rate hike, the third since the BoC began its tightening cycle in July 2017, followed a string of positive data releases in recent weeks. January’s decision came, however, amid renewed uncertainty among officials regarding the short-term economic outlook. In particular, concerns over the future of the North American Free Trade Agreement (NAFTA), which is currently being renegotiated with the U.S. and Mexico, prompted the BoC to acknowledge new doubts over the pace of future rate hikes. Nevertheless, the bank accompanied its policy decision with an upgrade to its growth forecasts for 2018 and 2019, to 2.2% from 2.1%, and to 1.6% from 1.5%, respectively.

The Bank’s decision was underpinned by the robust growth dynamics observed in recent months. Real sector data indicates growth has been above potential and will remain so until the end of the first quarter of 2018. Indeed, household spending has been benefiting from recent employment gains and wage growth. It has proven more resilient than expected in the face of heavy consumer debt and higher borrowing costs. Meanwhile, the recently passed tax legislation in the U.S. is expected to produce some positive short-term spillovers into the Canadian economy. On the other hand, negative signals from the external sector have tempered the otherwise optimistic outlook. Export data was weaker than expected, and the BoC expressed concern about the uncertainty regarding the future of NAFTA, which prompted it to adjust downwards its forecasts for business investment and trade.

BoC officials once again emphasized the Bank would remain cautious regarding the pace of adjustment, eschewing any timeline for future rate hikes. Uncertainty surrounding NAFTA has clouded the economic outlook, and the evolution of the negotiations will be an important factor influencing the BoC’s interest rate decisions in the coming months. Douglas Porter, Chief Economist at BMO Capital Markets, commented: “By making NAFTA risks so prominent in this statement, rate hike odds will now ebb and flow with the negotiations.” Measures of slack in the economy, particularly labor market slack, will also be a central point of focus for the Bank going forward, as wage growth has mostly remained subdued and its acceleration would signal a sustainable rise in inflation.

The next monetary policy announcement is scheduled for 7 March.

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