Why the Bank of Canada hiked interest rates

The Bank of Canada raised its benchmark interest rate a quarter point, to 0.75 per cent, the first increase in seven years. The central bank said it is now confident that gathering economic momentum is lasting. The institution said Canadian gross domestic product will expand 2.8 per cent in 2017, compared with an April forecast of 2.6 per cent.

The trend:
July 12, 2017 may go down in history as the day Canada shook off its hangover from the financial crisis. After dropping the the benchmark interest rate to a record low of 0.5 per cent to fight the Great Recession, former Bank of Canada Governor Mark Carney nudged the rate back up to one per cent in 2010. The economy never showed enough strength to go higher, and then the collapse of oil prices in 2014 forced current Governor Stephen Poloz to drop borrowing costs back to emergency levels in 2015.

What it means:
Market interest rates had already jumped, as officials had left little doubt that they intended to alter policy. The cost of borrowing money will be somewhat more expensive. It might not feel like it, but that’s a good thing. If the economy wasn’t doing better, the central bank wouldn’t have raised interest rates.

Glass half full:
At the start of the year, Poloz was so down on the economy that he said an interest-rate cut was possible. That sense of skepticism is gone; the central bank called the expansion “robust.” More industries are growing, and those regions hit by lower oil prices are coming back to life. Most of the world’s major economies are growing, which will be good for exports, and stronger exports will inspire business investment, the Bank of Canada said. And all that will be supported by consumer spending, at least in the short term: the central bank raised its outlook for growth in consumption in 2017 to 1.9 per cent from 1.4 per cent in April.

The Bank of Canada keeps its eye on something called the “output gap,” which is essentially the central bank’s best guess on how far away the economy is from operating at a level that would stoke inflation. In April, policy makers thought that gap would close sometime in the first half of 2018. They now think it will close at the end of 2017, so several months ahead of schedule.

Glass half empty:
The Bank of Canada is sticking with its old paradigm that a narrowing output gap means inflation is coming. The central bank concedes there is little evidence of price pressures in the inflation numbers themselves. Policy makers assume inflation will be back at its two-percent target by the middle of 2018, but said they will spend extra efforts studying price movements to get a better feel for why inflation indicators are so weak.

It’s also worth noting that the Bank of Canada doesn’t feel quite as good about the future as it does about the present. Growth will slow to 2 per cent in 2018 and 1.6 per cent in 2019, according to the forecast. The central bank cut its outlook for U.S. economic growth, as it now doubts President Donald Trump will make good on his pledge to cut taxes. In Canada, households are carrying so much debt that they can’t possibly continue spending at current rates.

Bottom line:
Finance Minister Bill Morneau said recently the economy was firing on all cylinders. The Bank of Canada’s latest assessment of the economy suggests he was right: the revision in the outlook for the output appears to be the trigger for the central bank’s shift in tone over the past month. Missing from the policy statement is a clue on whether policy makers intend to follow today’s increase with another one later this year. “Future adjustments to target for the overnight rate will be guided by incoming data as they inform the bank’s inflation outlook, keeping in mind continue uncertainty and financial system vulnerabilities,” the statement said. Weak inflation will continue to give the Bank of Canada cover if it opts for an extended pause.

MORE ABOUT INTEREST RATES:

• Bank of Canada raises key interest rate to 0.75%
• What an interest rate hike could mean for you
• Prep your portfolio for higher rates
• Lock in your mortgage now, before a possible rate hike
• Low interest rates have done their job: Poloz
• Why bond prices fall as rates rise
• What stocks to buy as rates rise
• How to inflation-proof your portfolio