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Rosenberg: The Bank of Canada picked a curious time to raise rates

Time will tell if the BoC’s tightening was prescient. But I come from the camp that says when uncertainty is running high, it’s best to do nothing.

David Rosenberg for The Financial Post

Interesting time for the Bank of Canada to have pulled the trigger, as it raised the policy rate 25 basis points last week to 1.5 per cent.

The move came after signs of decelerating growth in household credit demand and a slowing in wages, albeit from lofty levels. Not to mention that when you factor in the impact from the contraction in the workweek in June, the net effect was the equivalent of a 40,000 job loss (even after accounting for the headline gain, which was largely skewed by part-time employment in any event.)

And economic uncertainty caused by the Trump-inspired trade war is rising to its third-highest level on record.

The Bank has already moved four times this past year, matching the Fed. Now some may say that the Bank is coming off a lower level of the overnight rate, but that does not hold water. When you factor in the size of the Fed balance sheet, the Fed Fund rate is really -2.9 per cent. And don’t forget that it is the U.S. that is enjoying fiscal stimulus. Capacity constraints and inflation risks are far more acute in the U.S., especially in the context of the labour market.

It was only on March 13th of this year that the BoC’s governor Stephen Poloz delivered a speech titled Today’s Labour Market and the Future of Work, which concluded “that there remains a degree of untapped supply potential in the economy.”

To some extent, the press statement addressed this — “underlying wage growth is running at about 2.3 per cent, slower than would be expected in a labour market with no slack.” So the economy is not yet at full employment.

The Bank sees a 2.8 per cent real GDP growth rate in Q2 followed by a moderation to 1.5 per cent in Q3, and didn’t do much to the view that the economy grows close to 2 per cent in the 2018-2020 forecast period. This is not that far off from potential growth, so this means that we could well be stuck with an “output gap” two years down the road — one reason why inflation will not be able to return in any meaningful or sustainable capacity.

Indeed, as for the inflation threat, come on. The BoC acknowledges that there is still some slack left in the labour market, but based on their own projections, it could well be that the slack remains until 2021. As it stands, netting out the effects of gas prices and minimum wages, inflation is running at just 1.8 per cent.

Only time will tell if the BoC’s tightening move was a prescient one. But I come from the camp that says when uncertainty is running as high as it is, it’s best to sit on your hands and do nothing. Outside of the U.S., nobody else in the world is raising rates besides some emerging markets in defense of their sharply weakening currencies. While it is 100 per cent true that the Bank could always unwind the rate increase if need be, at the same time, it could have waited this one out to assess how the trade situation unfolds.

Even under its own forecast the output gap may not close, which means that the Bank does not exactly have to fret about its anti-inflation credentials. The Bank, to its credit, did incorporate the impact of the trade actions already implemented (and what Canada has done in retaliation), and the effects of all the uncertainty — the negative growth impact “is now judged to be larger given mounting trade tensions.” It is this last comment that leaves me wondering aloud, “So why hike?”

The Bank seems to be relying on business investment to pick up the baton given capacity constraints, but many of the sentiment surveys are not flashing a big capex pickup.

The Bank also sees exports carrying the day, but we have seen this song sung before. To be relying on U.S. demand growth once the tax cuts subside, in my view, is a dangerous forecast to have as your base case. Not to mention that the rest of the world is cooling off substantially, signalled by the downturn in cyclically-sensitive copper and base metals in general over the past few months.

At the same time, the Bank acknowledged that “household spending is being dampened by higher interest rates” — well, last week’s action is going to dampen that 60 per cent of GDP even more. So we had better get that export and capex offset, but the odds are we do not.

The question is whether it is possible, or even appropriate, for the BoC to have such a constructive view of the capex outlook considering what U.S. business contacts are telling the Fed?

From the last set of FOMC minutes: “Many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy.”

In conclusion, the question that must be asked is what is so special about Canada that only the BoC and the Fed have hiked rates this year of all the developed central banks? Not just once, but twice. Has the ECB gone? No. The BoE? No. The BoJ? No.

No others — just seven emerging market central banks who did so to defend their sagging currencies. At least the Fed can point to huge fiscal stimulus but what can the BoC really point to? An expected 2.8 per cent second quarter GDP growth performance followed by a relapse to 1.5 per cent this quarter? Wow.

The BoC has raised rates by 100 basis points this past year and the incremental debt service drain on the household sector will be more than $10 billion, or the equivalent of a 1 per cent pay cut. In other words, just less than half of the BoC’s blended estimate of where wage growth actually is (+2.3 per cent) will be offset by higher interest payments!

Nice, so long as you’re not long Canadian consumer discretionary stocks, that is.

David Rosenberg is chief economist and strategist at Gluskin Sheff + Associates Inc. and author of the daily economic report, Breakfast with Dave.

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