OTTAWA, Canada—With much less controversy than in January, the Bank of Canada cut its overnight rate target to 0.50 percent from 0.75 percent on Wednesday, July 15, seeing the worsening effects on the Canadian economy of the oil price shock and faltering growth in the U.S. and China.
With four straight months of GDP declines and weaker-than-expected exports, many economists were calling for a rate cut at the BoC’s July meeting, which also included the release of a new monetary policy report (MPR).
At its last rate-setting meeting on May 27, the Bank believed the Canadian economy was behaving in line with its then most recent projections from April’s MPR. No surprise emerged, as rates were kept unchanged.
The tune being sung then was that the oil price shock was more front-loaded but not larger than anticipated, and the pickup in non-energy exports due to a strengthening U.S. economy would keep Canada on track to close its output gap and reach its 2 percent inflation target by the end of 2016.
However, the Bank’s optimism or expectation has proven unrealized, which seems to be an ongoing global theme as the recovery from the financial crisis drags on.
“What has happened is the facts have changed quite quickly actually in the last two to three months,” Bank of Canada governor Stephen Poloz said during a press conference.
Business investment in the energy sector has fallen further as oil prices are expected to remain low. At the start of the year, the anticipated spending cut by oil patch companies was about 30 percent, but now it is around 40 percent. Thus it would seem the oil price shock is proving to be larger, in addition to being more front-loaded.
Another factor depressing Canada’s economy is the slowing of China’s economy as it transitions to being more domestically driven. This has implications for Canada’s commodities exports both in terms of value and volume.
And what’s most “puzzling,” as the Bank put it, is the weakness in non-resource exports, such as manufactured products and services. This category of exports had been a source of strength in 2014 and earlier this year.
Royal Bank of Canada assistant chief economist Dawn Desjardins was also expecting a bigger pickup in exports. “You’re anticipating something based on historical relationships [weak Canadian dollar, U.S. rebound in second quarter after weak first quarter], and sometimes it’s difficult to tell exactly why it hasn’t materialized,” Desjardins told Epoch Times.
Recession?
“Canada’s economy is undergoing a significant and complex adjustment,” stated the Bank in its rate decision press release.
That Canada is technically in a recession simply remains to be confirmed; after the economy contracted 0.6 percent in the first quarter, the Bank is projecting it to have contracted again in the second quarter.
Q2 growth was projected to come in at 1.8 percent in April, but has now been chopped to -0.5 percent. The third quarter’s growth projection of 2.8 percent has been nearly cut in half to 1.5 percent.
Now, instead of the economy reaching full capacity and the 2 percent inflation target by the end of 2016, the Bank anticipates getting there in the first half of 2017.
But while the Bank doesn’t want to use the term “recession,” it emphasized the two-track nature of the economy: the resource track and the non-resource track.
“Canada is a highly diversified economy,” Poloz said, pointing out that the energy sector makes up less than 20 percent of GDP.
The non-resource track makes up 83 percent of GDP and was the one the Canadian economy was expecting to lean on to move forward. However, although it “has continued to expand at a moderate pace,” its strength has also waned.
Nevertheless, since over 80 percent of the Canadian economy is not contracting, and labour markets have improved with 136,600 full-time jobs added this year along with a hot housing market, the term recession seems misplaced, even though it may fit the definition.
Desjardins describes the Canadian economy as going through “a bit of a stall.”
“It’s a concentrated part of the economy that’s come under this downward pressure,” Desjardins said. “If you look at the remaining part of the economy, we continue to see growth.”
Fine Balance With Housing
Poloz has spoken about a “neutral zone” for monetary policy, meaning inflation is at or expected to reach its target within a reasonable timeframe, and that financial stability risks (mainly household indebtedness and rising home prices) are evolving in a constructive manner.
That reasonable time frame, which previously was by the end of 2016, is no longer by then. However, despite the further rate cut and red hot housing markets in Toronto and Vancouver, the Bank still anticipates a “constructive evolution in the housing market, with housing activity expected to moderate over 2015 before stabilizing through 2016 and 2017 as the economy gains strength and household borrowing rates begin to normalize.”
High household debt and home prices are the vulnerabilities and the oil price decline is the trigger that could turn the vulnerabilities into a full-blown risk. The Bank is addressing the trigger, while “taking a chance that vulnerabilities will edge higher,” as Poloz put it.
The argument for the rate cut is to boost incomes, which would reduce the aggregate debt-to-disposable income or leverage ratio of households. The Bank’s rationale is that as the economy recovers later this year, bond yields are expected to move higher and mortgage rates will follow, i.e. “normalize,” which will help cool off the housing market—a “constructive evolution” once again.
The Bank remains optimistic that a turnaround is looming; it’s just been pushed further into the future. While it projects 2015 growth at just over 1 percent, it anticipates growth of about 2.5 percent for 2016 and 2017.
The slower growth and later return of the economy to full potential has the Bank now revising the underlying inflation trend to 1.5 to 1.7 percent, down 0.1 percent from April.
The BoC projects the U.S. economy to grow at 2.3 percent in 2015 and 2.8 percent in 2016, down from 2.7 and 3.0 percent respectively in April.
Tools Still Left
With the overnight rate target at 0.50 percent, the Bank doesn’t have much room to cut rates further should further shocks stun the Canadian economy.
To this point, Poloz says, “We have other tools in the toolkit.” These tools, or unconventional monetary policy, include forward guidance (influencing expectations of future interest rates), which has been used in the past by the Poloz-led central bank, and quantitative easing (central bank buys bonds), which has been used by many advanced economies coming out of the financial crisis.
Clearly the Bank is not expecting to have to go there, since once again, as in April and May, the BoC foresees a rebound as soon as the next quarter. A great deal rests on the U.S. economy gathering momentum, and Poloz says a rate hike south of the border would be welcome, as it would mean a more positive outlook.
“We’re still going to have weakness in the energy sector for the remainder of the year,” said Desjardins. She doesn’t expect oil prices to move up considerably, but all the other factors she considers leads her to believe a rebound is coming in the second half of 2015.
In financial markets, the Canadian dollar fell by about a cent against the U.S. dollar to US$0.774—a level not seen since 2009.
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