At 2.25 per cent, the Bank of Canada’s policy rate is currently at the bottom end of its estimated range for the neutral rate.Sean Kilpatrick/The Canadian Press
Jeremy Kronick is vice-president and director of the Centre on Financial and Monetary Policy at the C.D. Howe Institute, where Steve Ambler, a professor of economics at Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy.
On Wednesday, the Bank of Canada held its policy interest rate (the overnight rate target) at 2.25 per cent, in a move widely anticipated by financial markets. While the past year has often seen the debate centre on whether the bank should cut or not, next year could see as much discussion of a rate hike as a rate cut.
When the bank reduced its policy rate at its last announcement in October, despite the drop in second-quarter gross domestic product and a weak labour market, it strongly hinted that it was done with cuts for the time being.
“If inflation and economic activity evolve broadly in line with the October projection,” the bank said, “Governing Council sees the current policy rate at about the right level to keep inflation close to 2 per cent while helping the economy through this period of structural adjustment.”
If anything, the data since then have been stronger than expected. While there are a number of caveats to these positive surprises, on balance they justify the bank’s decision to remain on the sidelines.
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First, goods markets. Third-quarter GDP grew at an annualized rate of 2.6 per cent, beating market (and the bank’s) projections of 0.5 per cent. Furthermore, Statistics Canada revised its historical GDP data, which boosted economic growth between 2022 and 2024 by 1.7 percentage points. But strong third-quarter GDP growth was almost entirely trade-driven, in particular owing to a substantial drop in imports, which mechanically increases GDP as net exports increase. A drop in demand for any component of expenditure is not usually a sign of strength. Add a fall in household consumption, and the story is much less rosy.
The data revisions are certainly nice to see from a labour productivity perspective, but for the bank it’s unclear what it means for the likely path of inflation.
While realized GDP was higher than we thought, it says nothing about potential GDP, that is, what the Canadian economy is capable of producing at full employment. That metric is important because the output gap – the difference between actual (demand) and potential GDP (supply) – is what affects inflation.
Given the stubbornness of core inflation – Consumer Price Index-trim is at 3 per cent, CPI-median is at 2.9 per cent – you could make the case that the economy’s potential is unchanged, and higher actual GDP was responsible for keeping price growth elevated.
If true, this would close the output gap the bank has been estimating was negative. A negative output gap would possibly justify further cuts; a closed output gap, less so.
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Now let’s turn to the labour market. The latest Labour Force Survey showed unexpectedly strong employment growth in November. The economy added 54,000 jobs, beating market expectations of modest employment growth, and causing the unemployment rate to fall by 0.4 percentage points to 6.5 per cent.
But the increase in employment was driven by the addition of 63,000 part-time jobs, meaning full-time jobs fell by around 9,000. And those in the core 25-54 working age group saw job losses totalling 5,000, driven by a drop in almost 16,000 full-time jobs. The drop in the unemployment rate reversed the mostly increasing trend over the past three years, but it remains elevated, well above where it was in July, 2022 (4.8 per cent). This means there is still some slack in the labour market, which should keep upward pressure on wages (and therefore prices) at bay.
At 2.25 per cent, the bank’s policy rate is currently at the bottom end of its estimated range for the neutral rate, the rate compatible with inflation at the 2-per-cent target and the economy at full employment. Given the positive data surprises, but paired with what we see as underlying weakness, the lower end of the neutral rate range seems appropriate.
The bank is likely to remain on the sidelines well into the new year, as long as headline inflation, currently sitting at 2.2 per cent, continues to hover around the 2-per-cent target. As for the direction of rates, there are arguments both ways.
On the one hand, more fiscal spending is on the horizon, alongside elevated core inflation measures. On the other hand, there is a fair amount of underlying weakness in consumption, and uncertainty with the continued trade war. We still see a cut as the most likely next direction change – but would not be surprised to see a hike.