Dovish policy statement coming - Capital Economics
Canada Economics

Dovish policy statement coming

Bank of Canada Watch
Written by Stephen Brown

The potential for the coronavirus to develop into a pandemic is clearly the biggest risk to our view that the Bank of Canada will keep policy on hold this year. We expect the Bank to remain on the side lines next week, but it is likely to deliver a markedly more dovish policy statement.

  • Fourth-quarter GDP growth probably in line with Bank’s forecast
  • But possible coronavirus pandemic a key downside risk to the outlook
  • Bank to issue a very dovish statement while keeping policy unchanged

The potential for the coronavirus to develop into a pandemic is clearly the biggest risk to our view that the Bank of Canada will keep policy on hold this year. We expect the Bank to remain on the side lines next week, but it is likely to deliver a markedly more dovish policy statement.

Data developing in line with Bank’s expectations

During the press conference after January’s meeting, Governor Stephen Poloz told us that the door is open to an interest rate cut, but that only if growth weakens by more than the Bank expects. That has not been the case, with the data instead developing largely in line with the Bank’s forecasts.

Admittedly, our GDP tracker points to a 0.1% annualised contraction in the fourth quarter, which would be weaker than the Bank’s forecast for a gain of 0.3%. (See Chart 1.) But our tracker is probably not fully capturing the boost to growth in December from the resumption of the Keystone pipeline and the end of the CN Rail strike, so we expect the GDP data – due on Friday – to show that growth was more or less in line with the Bank’s expectations.

Chart 1: GDP (% q/q, annualised)

Sources: Refinitiv, Capital Economics

There has been little surprise from inflation either. It rose to 2.4% in January, while an average of the Bank’s three core measures remained at 2.0%.

Risks to growth

The bigger concern to the Governing Council will be the new threats to growth. When the Bank met in January, concerns about COVID-19 were only just coming to the fore. And since then, blockades by First Nations protestors have severely disrupted the rail network throughout Canada.

The blockades appear to have had a far worse impact on rail freight than the CN Rail strike in November. The delayed harvest in the prairies had already hit rail freight hard in September and October so, despite the strike, in November it declined by just 0.9% m/m. In contrast, the data for the first three weeks of February show rail freight down by 7.4% m/m. (See Chart 2.) That should translate into a hit to GDP of 0.25% in February, compared to less than 0.1% of GDP from the strike in November.

Chart 2: Rail Freight (% m/m)

Source: Refinitiv, Capital Economics

Now most of the blockades have been lifted, there is potential for growth to rebound strongly in March as the freight network returns to normal. While we have trimmed our forecast for first-quarter GDP growth to 1.5% annualised, from 1.8%, a rebound in March would provide a strong hand-over to the second quarter, when quarterly growth should be more than 2%. (See here.)

But that projected rebound assumes that any negative effects from the spread of COVID-19 are muted. For now, the direct threat looks small. The OECD’s Trade in Value Added (TiVA) database provides the broadest picture of total value added from trade with other economies, capturing direct goods and services trade as well as the gains from indirect relationships that take place through complex supply chains. The most recent data show that demand from the countries that have been most affected so far, China, Japan, South Korea and Italy, account for a relatively small 2.3% of gross value added in Canada, less than the 4.5% for Germany or the 7.1% for Australia. (See Chart 3.)

Chart 3: Contributions of Exports to Select Partners to Country’s Gross Value Added (%)

Sources: OECD, Refinitiv, Capital Economics

In the worst affected country, China, we estimate that the disruption will cause an enormous 25% q/q annualised drop in GDP in the first quarter. Chart 3 implies that if China’s imports fell by a similar amount, it would subtract 0.4%-points from annualised GDP growth in Canada. Yet the rail blockades had already crippled the freight network anyway. And daily data on port traffic from Australia, which like Canada sends mostly raw materials to China, shows that departures of ships to China have already started to pick up again, as the Chinese authorities try to get the country back to work. With cases of the virus in China plateauing, the bigger threat seems to be the potential for COVID-19 to spread much more widely across the globe and to cause more direct disruption in North America.

Growth at risk

The blockades and the virus risks certainly give the Bank justification to cut interest rates if it wanted to, especially with markets now pricing in an additional 25bp worth of loosening this year compared to when the Bank last met. (See Chart 4.)

Chart 4: Policy Rate (%)

Sources: Bloomberg, Refinitiv, Capital Economics

The Bank’s communications suggest that it is still keen to avoid loosening policy, however. Earlier this month, Deputy Governor Paul Beaudry explained how the Bank has begun to incorporate financial risks into its decision making. The Bank now produces two sets of forecasts internally, the baseline forecasts that we see in the Monetary Policy Report and a set it calls “growth-at-risk”. The latter are supposed to reflect a plausible worst-case scenario for growth based on the level of financial vulnerabilities in the economy. (See here.)

Beaudry told us that the reason the Bank did not follow central banks elsewhere in the world in cutting interest rates in 2019 was that, while loosening policy would bolster its base-case growth forecasts, they would also cause the growth-at-risk forecasts to worsen by incentivising households to take on more debt. The Bank’s fears about the downside risks from cutting interest rates may have risen, given the plans announced last week to reduce the severity of the mortgage stress tests. (See here.)

Accordingly, we think that the Bank will approach the risks from COVID-19 in the same way that it approached the risk from the US-China trade war last year. It hinted that it was prepared to loosen policy if necessary, and is likely to do the same thing next week by delivering what could be its most dovish statement in years. But given the risks of looser policy to financial stability, we continue to think that the Bank is unlikely to follow through with action unless there is firmer evidence of sustained weakness in the domestic data.

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

Stephen Poloz

Senior Deputy Governor

Carolyn Wilkins

Deputy Governors

Timothy Lane

Lawrence Schembri

Paul Beaudry
Toni Gravelle

Fixed Announcement Dates

Date

Outcome / Our Forecast

July 10th

No Change (Rate to stay at 1.75%)

September 4th

No Change (Rate to stay at 1.75%)

October 30th

No Change (Rate to stay at 1.75%)

December 4th

No Change (Rate to stay at 1.75%)

January 22nd 2020

No Change (Rate to stay at 1.75%)

March 4th

No Change (Rate to stay at 1.75%)

April 15th

No Change (Rate to stay at 1.75%)

June 3rd

No Change (Rate to stay at 1.75%)

July 15th

No Change (Rate to stay at 1.75%)

September 9th

No Change (Rate to stay at 1.75%)

October 28th

No Change (Rate to stay at 1.75%)

December 9th

No Change (Rate to stay at 1.75%)

Sources: Bank of Canada, CE


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