Bank to turn forward guidance up to eleven - Capital Economics
Canada Economics

Bank to turn forward guidance up to eleven

Bank of Canada Watch
Written by Stephen Brown
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Although the economy has been stronger than expected, we doubt that the Bank of Canada is about to become more hawkish. Instead, we think the Bank will use its policy statement next week to double-down on its commitment to keep the policy rate unchanged for a prolonged period, in order to support a full recovery in the labour market and minimise economic scarring.

  • Economy has outperformed the Bank’s forecasts
  • But output still far from potential and Bank emphasising need for inclusive recovery
  • Bank to push back against expectations it will raise rates in 2022

Although the economy has been stronger than expected, we doubt that the Bank of Canada is about to become more hawkish. Instead, we think the Bank will use its policy statement next week to double-down on its commitment to keep the policy rate unchanged for a prolonged period, in order to support a full recovery in the labour market and minimise economic scarring.

Economy doing better than the Bank expected

In what is admittedly becoming a familiar story, the economy has outperformed the Bank’s forecasts since its last meeting. GDP rose by 9.7% annualised in the fourth quarter, which was twice as strong as the Bank’s projection from January. What’s more, the preliminary estimate that GDP rose by 0.5% m/m in January, and the likelihood that the economy will grow at a decent pace in February and March now that coronavirus restrictions are being eased, puts the economy on track for a first-quarter expansion of 4% annualised. That is far better than the Bank’s recent forecast for a 2.5% contraction.

Other recent developments also bode well for the outlook. The US appears to be on the cusp of another major stimulus which, even with enhanced Buy American clauses, will be beneficial for Canada. The increased chance of stimulus helps to explain the further rises in commodity prices, with WTI now $10 higher than the Bank assumed in January and copper, iron and lumber prices also elevated.

Against this backdrop, the rise in bond yields in recent weeks (see Chart 1) might not seem all that surprising. After all, while the Bank reiterated in its January policy statement that it wants to “keep interest rates low across the yield curve”, it added the line that, “as the Governing Council gains confidence in the strength of the recovery, the pace of net purchases of… bonds will be adjusted as required.” This seemed to be a sign that the Bank would tolerate, or even eventually encourage, a rise in bond yields.

Chart 1: Bond yields (%)

Sources: Refinitiv, Capital Economics

Market pricing has gone too far

While we agree with this idea in principle – our own forecast was for a rise in the 10-year yield to 1.5%, which it is now close to hitting – we think the Bank will view recent developments as market pricing going too far, too soon. The recent jump in yields has been driven mainly by a sharp rise in real yields, which has reflected a re-pricing of the implied policy rate. Overnight index swaps (OIS) now suggest the Bank will raise rates in 2022, rather than waiting until 2023 as it has previously said. (See Chart 2.)

Chart 2: Policy Rates Implied by OIS (%)

Sources: Refinitiv, Capital Economics

As the Bank has indicated that it will keep its policy rate at 0.25% until economic slack is absorbed, the implication of current market expectations is the Bank will pull forward by 12 months its forecast of when the output gap will close – to early 2022. However, we think the logic behind the recent repricing rests on two flawed assumptions.

The first flawed assumption is that the Bank’s estimate of potential GDP is fixed. The Bank’s baseline projections imply potential GDP will be almost 2.5% lower in 2023 than it thought before the pandemic, but it also tells us that, given the unprecedented nature of the situation and the large policy response, it is possible the pandemic has done little permanent damage. For example, a few months ago most forecasters assumed that it would take years for oil production to fully recover, if it did at all. Yet in Canada at least, that has already happened. (See here.) We think it is likely that future upgrades to the Bank’s growth forecasts will be matched with upgrades to its estimates of potential GDP.

The second flawed assumption is that the Bank is as wedded to its output gap framework as it was in the past. While the output gap estimates are a huge part of the Bank’s thinking, because they are the main input into its inflation forecasts, there are clear signs both in Canada and elsewhere that central bankers are no longer convinced about their forecasting power. Governor Tiff Mackem noted in a speech last week that, despite the unemployment rate being near a 40-year low for years before the pandemic, “inflation wasn’t threatening to take off”.

Governor Tiff Macklem seems to be trying to shift the Bank toward a more holistic view of the economy with a greater emphasis on the labour market. He also argued last week that the Bank has “shared responsibility to get Canadians back to work”, with a particular emphasis on female and youth employment. Just as importantly, Macklem argued that this is not just about keeping rates low until vaccines are available, but also about ensuring that no segment of society is left behind by the ongoing shift toward automation and digitalisation.

Admittedly, Macklem may find it harder to advocate for broader employment goals if there are sign that overheating elsewhere will jeopardise the Bank’s ability to meet its inflation target. But with long-term inflation breakevens still relatively low, we are a long way from that being an issue. (See Chart 3.)

Chart 3: Inflation Compensation Implied by Real Return Bond Maturing in 2036 (%)

Sources: Refinitiv, Capital Economics

Bank to provide firmer guidance

While we doubt that the Bank is about to get more hawkish with regard to its view on the policy rate, the outlook for its government bond purchases is trickier to judge due to signs it may be concerned about the share of outstanding bonds that it owns.

Macklem has hinted that the Bank would be concerned if it owned more than 50% of the bonds outstanding, which it is on track to do by the fourth quarter at the current pace of purchases, of $4bn per week. The Bank might judge that it would be beneficial to spread its purchases over as long a period as possible to enhance its message on the policy rate. That is, if it wanted to purchase, say, an additional $170bn of bonds, it might prefer to purchase $3bn per week so that those purchase last until the middle of 2022, rather than $4bn per week so they finish in December.

There still seems little chance the Bank will announce a cut to the pace of its purchases next week, however, and we would be surprised if it did so in April, as some forecasters are now suggesting. That is partly because the Bank’s policy announcement will come just 90 minutes after the March inflation data, which are set to show a jump in inflation to more than 2%. If the Bank timed a decision to cut its bond purchases with that news, it would risk sending bond yields soaring.

We therefore doubt that the Bank will cut the pace of its purchases any time soon, although there does seem to be reason to think that it could act at the June or July meetings rather than waiting until September as we previously suggested.

Table 1: Bank of Canada Background Information

Policy Interest Rate Announcements

The Bank of Canada has a system of eight pre-set dates per year on which it announces its target for the overnight interest rate (10.00am EST).

Release of Minutes

No. However, the Bank’s Monetary Policy Report (MPR), published four times a year, provides considerable detail on the Governing Council’s outlook for economic activity and inflation, the key risks around this outlook, and the reasons for the recent interest rate decision.

Disclosure of Voting

No.

Inflation Target

Yes. The Bank aims to keep inflation at 2%, the midpoint of a 1% to 3% range.

Policy Framework

Canada’s monetary policy is built on a framework consisting of two key components. The first component is a flexible exchange rate, which permits independent monetary policy. The second component is the inflation target of 2%, which provides a precise goal to measure the conduct of monetary policy.

Membership of the Governing Council

The Governing Council is the policy-making body of the Bank. It consists of the Governor, Senior Deputy Governor, and four Deputy Governors.

Governor

Tiff Macklem

Senior Deputy Governor

Carolyn Wilkins (Departing December 2020)

Deputy Governors

Timothy Lane

Lawrence Schembri

Paul Beaudry
Toni Gravelle

Fixed Announcement Dates
*denotes release of Monetary Policy Report

Date

Outcome / Our Forecast

March 4th

Cut (Rate reduced to 1.25%)

March 13th

Cut (Rate reduced to 0.75%)

March 27th

Cut (Rate reduced to 0.25%)

*April 15th

No Change (Rate stayed at 0.25%)

June 3rd

No Change (Rate stayed at 0.25%)

*July 15th

No Change (Rate stayed at 0.25%)

September 9th

No Change (Rate stayed at 0.25%)

*October 28th

No Change (Rate stayed at 0.25%)

December 9th

No Change (Rate stayed at 0.25%)

*January 20th

No Change (Rate to stay at 0.25%)

March 10th

No Change (Rate to stay at 0.25%)

*April 21st

No Change (Rate to stay at 0.25%)

June 9th

No Change (Rate to stay at 0.25%)

*July 14th

No Change (Rate to stay at 0.25%)

September 8th

No Change (Rate to stay at 0.25%)

Sources: Bank of Canada, CE


Stephen Brown, Senior Canada Economist, +1 416 874 0514, stephen.brown@capitaleconomics.com