Posted by: Daryl & Wendy Ashby | June 1, 2010

Hold the Elevator

The Bank of Canada commenced tightening of monetary policy with a 25 basis point hike, increasing the overnight target rate to 0.50%.

This move was widely expected given the strong first quarter GDP performance and acceleration in core CPI. Having taken the overnight target rate off its lower bound, the Bank also normalized the operating band, reestablishing its deposit rate and lending (the “Bank Rate”) at 25 basis points below and above the target, respectively.

The text of the announcement highlighted Canada’s strong performance, observing the robust first quarter growth and resumption of employment growth. It pointed to the strength of domestic demand through the housing and consumer spending.

However, the Bank stressed that household expenditures will necessarily moderate to pace more in-line with income growth, reducing the contribution from consumption and residential construction in the coming quarters. Moreover, the Bank observed that business investment still has yet to take the baton, noting that “the anticipated pick-up in business investment will be important for a more balanced recovery”.

The statement was also keenly attentive to the international setting and its downside risks. Although the volatility from sovereign debt fears has somewhat subsided in the past weeks, the Bank notes that the Eurozone tensions will likely prompt increased borrowing costs and more rapid fiscal consolidation for some countries.

While the Bank observes that spillover to Canada has so far been modest and limited to commodity prices and some heightened financial stress, it observes that the “broad forces of household, bank and sovereign will add to the variability, and temper the pace, of global growth.”

Looking ahead, anticipating a moderating clip for domestic demand and bearing the recent global volatility in mind, the Bank stressed the “considerable uncertainty surround the outlook” and stated that “any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.”

Key Implications

Remembering that monetary policy only impacts with a lag, the exceptional near-term performance of the Canadian economy and stickiness in core inflation point to a necessary tightening to begin to restrain price growth.

The Bank of Canada has the sole mandate of achieving its 2% inflation target and conducts its policy through that exclusive prism.

Although the near-term economic strength will ebb, the uptake of slack and rebound in price growth meant it was due time to take interest rates off their emergency level at the effective lower bound.

Nonetheless, today’s 25 basis point increase represents a modest tightening and still leaves rates at very accommodative levels.

The decision does mean that a rebalancing of monetary policy has commenced and interest rates will be lifted as economic slack is absorbed to restrain price growth. Nonetheless, the wording of the announcement indicates that in undertaking subsequent rate hikes the Bank will remain very attentive to the likely moderation in domestic demand and developments in the global financial system.

While the Bank took the “elevator down” when cleaving rates, ongoing uncertainties and an easing pace of growth point to a very careful pace of tightening. The Bank may not hike at each meeting and might “pause” on increases if near-term financial conditions warrant. The emphasis on global conditions in today’s communiqué is no accident and, after the rocky last couple of years, policy-makers are keenly aware that Canada is not an island.

Barring unforeseen shocks in global financial markets, based on our outlook for economic growth and inflation, we anticipate a sequence of 25 basis point increases at subsequent announcements, with the overnight rate at a still-stimulative 1.50% by year’s end.

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