Bank of Canada Set to End Year on Pause After Two Summer Hikes

(Bloomberg) -- Governor Stephen Poloz is expected to stay on hold at his last interest-rate decision of 2017, capping a year that saw the Bank of Canada start the delicate process of raising borrowing costs to more normal levels.

Investors are assigning a 20 percent chance of an increase at the decision Wednesday, with a statement to be released at 10 a.m. Ottawa time. Only four of 26 economists surveyed by Bloomberg News expect Poloz to increase his 1 percent benchmark rate, with all major Canadian banks expecting a pause.

Central bank policy makers -- who raised borrowing costs for the first time in seven years in July and September -- are handling the normalization of policy very carefully. By their own measure, interest rates are still a full 2 percentage points below what they would consider “neutral” but the Bank of Canada is wary of raising borrowing costs too quickly for fear of inadvertently triggering another downturn.

Investors anticipate as many as three more hikes by the end of 2018 with the first in March, swaps trading suggests.

Rates will need to rise to account for an economy that has been one of the strongest in the developed world with a jobs market on a tear. Even with an anticipated second-half slowdown, Canada is headed for 3 percent growth for all of 2017. That's almost a percentage point above U.S. growth and has prompted some to question whether historically low interest rates -- currently at below the rate of inflation -- are appropriate for an economy at near its full capacity.

“We continue to think the central bank will be forced by strong data to deliver more interest rate hikes than what markets are currently expecting for 2018,” National Bank of Canada economists Stefan Marion and Krishen Rangasamy said in a note to investors Monday.

‘Complex Trade-Offs'

But there is also a case to be made for caution, and central bank policy makers have spent much of the past two months making it.

“Whether it's about how aggressive or how cautious policy should be -- getting the dosage right demands sound judgment about complex trade-offs,” Bank of Canada Senior Deputy Governor Carolyn Wilkins said in a Nov. 15 speech, the last by a central bank governing council member before the decision.

One argument against rate increases is weak inflation, which has undershot the central bank's 2 percent target for years. If the economy can continue expanding at a fast clip without overheating, policy makers can afford to wait longer before raising interest rates.

The Bank of Canada has also been voicing a narrative that the economy is at the “sweet spot” of the business cycle where growing demand is actually generating new capacity as companies invest to meet sales. The idea essentially is that demand can actually generate supply, at least temporarily, limiting price pressures.

The central bank has cited a number of other reasons for its caution:

• Policy makers are worried about the impact of higher borrowing costs on the ability of Canadians to pay their bills -- and the nation is carrying the heaviest household debt burden in the Group of Seven, by far.
• Growing risks associated with renegotiation of the North American Free Trade Agreement.
• A slowing housing market coupled with the impact of new regulatory measures to rein in lending.
• Continued evidence of slack in the labor market despite the unemployment rate being at a decade low.

There is also the impact higher interest rates could have on the Canadian dollar. Policy makers were spooked earlier this year by a sharp gain in the currency following its two rate increases that spurred expectations the Bank of Canada would outpace the Federal Reserve's hiking path.

Talk of caution has helped weaken the currency by almost 5 percent since the September rate hike, and brought policy expectations more into sync with the Fed. Bank of Canada officials may be more comfortable with that.

--With assistance from Erik Hertzberg and Catarina Saraiva

To contact the reporter on this story: Theophilos Argitis in Ottawa at targitis@bloomberg.net.

To contact the editors responsible for this story: Theophilos Argitis at targitis@bloomberg.net, Stephen Wicary

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