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Bank of Canada raises rates

Bloomberg logoBloomberg 2018-07-11 Theophilos Argitis

(Bloomberg) -- Bank of Canada Governor Stephen Poloz brushed aside concerns about trade wars and pressed ahead with a fresh interest rate increase as inflation hovers at its highest in seven years.

The Ottawa-based central bank raised its overnight benchmark rate by a quarter point to 1.5 percent on Wednesday,the second hike this year and fourth over the past 12 months.The statement didn't introduce any new “dovish” language, with officials only reiterating that rates will need to rise further,albeit gradually, to keep price pressures in check.

“Governing Council expects that higher interest rates willbe warranted to keep inflation near target and will continue totake a gradual approach, guided by incoming data,” the bank said.

The rate move signals policy makers are determined to bringrates back to normal levels, and are confident in the Canadian economy’s ability to cope with both higher borrowing costs and the mounting trade tensions.

Key Takeaways

Bank of Canada raises benchmark rate by a quarter point to 1.5 percent

Statement includes no new “dovish” language, with officials reiterating more hikes are coming back but in gradual way

Bank of Canada paints an economic picture in which higher oil prices, a weaker Canadian dollar and stronger-than- expected business investment is fully offsetting the negative effect of trade uncertainty

In its statement and accompanying monetary policy report,the central bank described an economy running close to capacitydespite growing trade frictions. Exporters, meanwhile, are doingeven better than previously estimated because of buoyant foreigndemand.

The Bank of Canada forecast growth will average 2 percentover the next three years, unchanged from its last estimate inApril and still slightly higher than what officials believe is the economy's long-term sustainable pace. The latest growth forecasts incorporate negative adjustments that capture greatertrade uncertainty.

The central bank also raised its estimates for inflation,but expressed confidence it would settle back to 2 percent aftertemporary factors drove the rate above target.

In another positive development, officials highlighted thatthe composition of growth is shifting away from consumption toexports and business investment -- implying they believe theexpansion is more sustainable.

Fully Priced

Wednesday's move was fully priced in by markets. Investorshave also been anticipating additional hikes every six months orso until the benchmark rate settles around 2 or 2.25 percent bythe end of 2019 -- in line with the central bank's gradualistguidance.

The increase in borrowing costs also puts the Bank Canadamore in sync with the Federal Reserve and investors are nowexpecting the northern nation to keep track with rate hikessouth of the border over the next year. The Bank of Canada hasbeen lagging the Fed’s rate increases since oil prices collapsedin 2015 -- marking a rare divergence given how closely Canada’seconomy is linked to the U.S.

Rate normalization is a delicate task for Poloz. Withinflation already above the central bank’s 2 percent target andheading higher, and with financial conditions still very loose,the central bank chief needs to keep wage and price pressures incheck. At the same time, moving too soon and too fast couldinadvertently trigger a downturn at a time when the economy isawash in risk.

Rate Sensitivity

The Bank of Canada repeated most of the list of concernsand unknowns it has said is keeping it from an even fasternormalization -- in addition to trade. Officials reiterated, forexample, how the economy has become more sensitive to higherinterest rates given high debt levels.

The central bank continued to show faith in the economy’sability to prolong its current expansion without fuelinginflation -- in part because it believes there remains excesscapacity in the labor market. The Bank of Canada estimatedunderlying wage pressures are at 2.3 percent, less than whatwould be expected in a jobs market that had no slack.

Policy makers are also anticipating that higher businessinvestment will generate new capacity as companies invest tomeet sales, a process the central bank has said it has an“obligation” to nurture with stimulative borrowing costs.Because business investment in the first quarter was more robustthan expected, the central bank slightly increased its estimatefor potential output growth in 2019 and 2020.

Other Highlights

The central bank kept its 2 percent growth estimate unchanged for 2018, and raised it one-tenth of a percentage point in 2019 and 2020 on stronger consumption

The bank kept estimates for global growth unchanged from April, but said U.S. economy is stronger than expected

Canadian dollar is lower despite higher oil prices due to broad-based U.S. dollar strength and trade actions

Recent data suggest housing markets are beginning to stabilize

Exports are being buoyed by strong global demand and higher commodity prices

©2018 Bloomberg L.P.

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