On April 21 the Governing Council of the Bank of Canada (BoC) will meet to discuss monetary policy. After the global COVID-19 pandemic necessitated extraordinary interventions by both global central banks and fiscal authorities, many investors believe that the BoC’s April meeting will mark the first developed market (DM) central bank to begin normalizing monetary policy, by announcing a reduction in the monthly pace of government of Canada (GoC) bond purchases. We think the decision, however, like many faced by central bankers, is not so straight forward.
In fact, the bank must weigh the brighter outlook for U.S. growth, which will also support Canada, against more worrisome trends in domestic public health, including the recent rise in new COVID-19 cases and its more contagious, more severe variants. In the end, we think Deputy Governor Toni Gravelle’s recent speech (read the speech here) sent a strong signal that the Governing Council will announce the first reduction in bond purchases in April. We remain cautious, however, of the economic risks of a premature tightening in financial conditions, which could choke the Canadian recovery.
Canadian government bond yields have increased along with global rates, while the Canadian exchange rate has strengthened against the currencies of Canada’s largest trading partners. These tighter financial conditions appear manageable for now against the economic boost generated by elevated trade and oil prices. Nonetheless, domestic and foreign growth can be choppy and uneven after recessions, making a policy approach focused on risk management prudent.
The Canadian outlook is brightening…
The governing council’s updated economic projections, which will be released along with the April monetary policy statement, are likely to reveal a brighter economic outlook for Canada, and include revised guidance for when the economy might sustainably achieve its inflation target.
Several positive developments since the January monetary policy report (MPR) suggest the medium-term growth outlook has improved. Specifically, the U.S. federal government significantly increased spending on COVID-19 relief programs, crude oil prices jumped roughly 30%, and the Canadian economy proved more resilient to the wider virus spread in January.
We estimate that the positive impact on Canadian exports of higher U.S. growth, coupled with elevated energy prices, which will reaccelerate Canadian oil output, will likely contribute 1 to 1.5 percentage points (ppts) to 2021 real GDP growth, lifting it to 6% year-over-year in the fourth quarter (up from 4.6% in January). As a result, the governing council will also likely revise its timing for when the economy will reach its potential, and therefore when inflation is expected to run sustainably at its 2% target from 2023 to mid-2022.
…but public health trends are worsening
However, despite the brighter medium-term outlook, we would argue that near-term economic risks remain, and industries that have been most impacted by the pandemic are likely to remain weak. Canada lags the U.S. in administering vaccines, with the majority of its population expected to be vaccinated around the end of this year or slightly later – roughly six months later than the U.S. Against this, the recent acceleration in new COVID-19 cases and the growing prevalence of the disease’s new variants will likely necessitate another round of economic restrictions. Last week, Premier Doug Ford of Ontario – Canada’s most populous province – announced a four-week stay-at-home order (read the announcement here) and other provinces could follow.
Luckily, many of the Canadian federal government’s COVID-19 relief programs aren’t set to expire until the summer and even then we would expect the government to extend them if economic conditions warrant. Nonetheless, these trends suggest monetary policy should be managed with a continued focus on mitigating potential downside risks and avoiding a premature tightening in financial conditions.
…so the tapering decision is not clear cut
Although Deputy Governor Gravelle’s recent speech strongly hinted that the BoC is likely to announce the first reduction in the monthly pace of the central bank’s government bond-buying program when they meet this month, we think the decision isn’t so clear cut for a few reasons:
- Rising COVID-19 cases and economic restrictions are likely to continue to constrain growth – especially in the retail and services sectors of the economy. While stronger U.S. growth and rising energy prices should support the manufacturing, trade, and mining sectors, policymakers should still want to avoid a premature tightening amid financial conditions – such as the appreciating exchange rate – that could choke the recovery.
- Waiting won’t adversely impact market liquidity, in our view. Although the BoC currently holds over 35% of GoC bonds outstanding – more than other developed market central banks – their ownership proportion will shrink due to its primary market T-bill purchase policy.Footnote[i] Furthermore, we estimate the government may need to issue over C$200 billion of bonds this year to fund the deficit and continue to term out the T-bills that funded government programs last year.As a result, BoC holdings as a percent of debt outstanding will begin to shrink by year-end whether they wait a little longer or not.
- Financial stability risks are manageable. The rapid rise in home prices has raised concerns about risks of a bubble. For now, though, we think those risks are manageable, with continued government measures to support incomes through the pandemic, and restrictive macroprudential policies in place. Indeed, despite rapidly appreciating home prices, lending standards remain relatively tight and could tighten further. The Office of the Superintendent of Financial Institutions (OSFI) recently proposed (read the proposal here) increasing the qualifying rate for uninsured mortgages, which will further ensure that borrowers who put down less than 20% can make mortgage payments if rates rise or incomes decline.
…and the Canadian Phillips curve is flatter than in the U.S.
Although the BoC is also likely to pull forward their guidance for when rate hikes are likely to begin (from 2023 to 2022), we don’t think they should be in a hurry to raise overnight rates. Although the Canadian labor marketFootnote[ii] has rebounded more than in the U.S., real growth has lagged, and labor market vitality has been driven mainly by government programs, including the Emergency Wage SubsidyFootnote[iii], which has helped over 3.9 million workers. Moreover, the Canadian Phillips curve (the link between labor market slack and inflation) is flatter than the U.S., because the exchange rate has a greater influence on Canadian inflation.
As a result, even though employment will likely reach pre-pandemic levels before year-end, ongoing government support remains necessary to maintain the higher level of labor market utilization. And this government dependency, coupled with the greater influence of the exchange rate on inflation, argues for a slow and prudent approach to tapering monetary policy.
Over the next several quarters the Bank of Canada will be walking a tight rope, where they must balance the improved growth outlook, which has been driven by external factors, against still weak domestic fundamentals and worsening trends in public health. At the April meeting they are likely to announce a reduction the pace of their GoC purchases, and pull forward the calendar-base rate guidance. However, by doing this, we think they risk overly tightening financial conditions. In our view, the bank can be patient, given the relatively flat Phillips curve and the ongoing need for government support. The risks of a premature tightening are likely greater than the risks of waiting a bit too long.
After the recent rate market sell-off, we believe longer-term interest rates in Canada (and the U.S.) are in line with levels warranted by the brighter medium-term outlook. Nonetheless, over the next several months we see risks of heightened volatility in Canadian financial markets and in the currency as investors weigh pandemic-weakened domestic fundamentals against the stronger outlook for growth in sectors tied to manufacturing, trade, and energy. As a result, we prefer to keep our interest rate risk low, while still positioning for some modest steepening of the yield curve. Five-year maturities look particularly attractive, as the market is pricing aggressive BoC tightening with as many as four interest rate hikes priced by the end of 2023.
Tiffany Wilding is an economist focused on North America. Vinayak Seshasayee is a portfolio manager focused on Canada. Both are regular contributors to the PIMCO Blog.