E-sight January 20: Bank of Canada Sends a Clear Message while Inflation Decelerates

The Bank of Canada left its policy rate at 0.25% this morning and sent a clear message to markets that the overnight rate would stay at that level until its inflation objective is achieved. This comes after speculation in recent days that the Bank may be looking at a micro cut of 10 to 15 basis points. The decision to hold rates makes sense given that changes in interest rates take 12 to 18 months to be fully felt and therefore, interest rate changes today will not help soften the current pandemic-induced economic downturn that should end once health risks diminish and vaccination coverage increases.

In addition to holding the line on interest rates, the Bank is maintaining its forward guidance and quantitative easing (bond buying) program, valued at a minimum of $4 billion per week, in order to keep interest rates low along the yield curve.

The Bank also released an updated economic projection today that shows a downward revision to the very near-term outlook and an improvement in medium-term prospects. Across many parts of the word, a resurgence of COVID-19 infections is necessitating restrictive public health measures, and this will weigh on demand in the near term. The Bank is predicting that real GDP in Canada will fall by 2.5% in the first quarter before bouncing back in the second as businesses reopen and consumer confidence and foreign demand improves. This is very close to our own forecast which calls for a 3.1% decline in the first quarter before loosening public health measures lead to a bump higher in second quarter growth.

Overall, the Bank of Canada expects that the economy shrank 5.5% last year and will grow by 4% this year and 4.8% in 2022. This is nearly identical to our own forecast which expects growth of 4.2% this year and 4.9% next year.

The most significant revision in the Bank’s outlook comes next year as the earlier than anticipated arrival of vaccines will allow for a quicker recovery in the second half of this year. In October, the Bank was expecting real GDP growth of 3.7% in 2022 meaning they’ve revised their outlook for next year by a full 1.1 percentage points.

With the fourth quarter of last year coming in better than they expected, the Bank estimates that the output gap shrank to between -3.75% and -2.75% last quarter. An output gap of that size would leave the economy with the same degree of excess capacity as during the peak of the financial crisis.

With the Bank driven by an inflation mandate, this morning’s Consumer Price Index (CPI) report reinforces the notion that interest rates are not going up any time soon. Inflation was up 0.7% in December, a deceleration from the 1% growth we saw in November – a pace of inflation well below the Bank’s 2% inflation target.

Despite downward pressure from low interest rates, shelter costs were 1.6% higher than last year as new home prices were up strongly given robust demand and shifting consumer preferences towards larger homes. Transportation and clothing and footwear continue to put downward pressure on overall prices as demand remains weak in these categories.

The average of the three measures of core inflation nudged down from 1.7% in November to 1.6% last month. CPI-common, the Bank’s preferred measure, continues to post the softest growth at just 1.3% in December, down 0.2 percentage points from November.

Overall, the Bank’s policy stance and today’s inflation report are very much aligned with our current thinking on the economy, which you can find in our latest publication available at https://www2.deloitte.com/ca/en/pages/finance/articles/economic-outlook.html.

Categories: Bank of Canada, Canadian Inflation, E-Sight, Economics

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