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A persistently sluggish global economy and ableak outlook for the energy sector mean that interest rateswon't need to rise as much as the Bank of Canada once thought,even if all economic headwinds eventually dissipate.
The so-called neutral rate is the estimated policy stancethat keeps the economy from running too hot or too cold when allslack has been absorbed and there is nothing blowing it offcourse, like a trade war. It's what is expected to prevail innormal economic times, and is affected by a mix of global anddomestic factors.
Because of significant uncertainty surrounding thisvariable, which cannot be directly observed, the Ottawa-basedcentral bank presents it as a range of 2.25 to 3.25 percent. Themidpoint of the range was revised down 25 basis points onWednesday from its previous estimate, and more than twopercentage points below its assessment from the mid-2000s.
This downward revision may come as a sigh of relief fordebt-laden Canadian households, which are currently seeing thegrowth of debt payments outstrip the increase in income by themost since the financial crisis, thanks in part to the Bank ofCanada's five interest rate hikes since mid-2017.
It's an acknowledgement that forces weighing on globalgrowth are more structural in nature -- and as a result theCanadian economy has less need for higher rates.
Fed Disconnect
Wednesday's change also remedies an odd disconnect in whichthe Bank of Canada's estimate of the neutral rate was higherthan the Federal Reserve's, despite a long history of subparproductivity growth and the Canadian mortgage market's greatersensitivity to policy changes.
The approach taken by the Bank of Canada is simply to takethe median estimate of the neutral rate from the Fed, consideredthe world's central bank, and tack a 50-basis point range oneither side.
Staff research at the Bank of Canada, released Wednesday,suggest that using alternative methods that are more Canada-centric may generate an even lower neutral rate.
An area for future study would involve how to incorporatethe onerous burden faced by Canadian households into the Bank ofCanada's assessment of the neutral rate.
Financial markets, for their part, never bought into theidea that the Bank's policy rate would ascend to 3 percent overforeseeable projection horizons.
Potential Growth
Canada's economy isn't able to sustainably grow as fast asonce hoped -- something the Bank of Canada acknowledged again onWednesday by revising down its estimates for potential output.
The two concepts -- neutral and potential -- areinextricably intertwined. In an April 2016 speech, Bank ofGovernor Stephen Poloz indicated that the underlying growth ineconomic potential was “the most important input” into theneutral rate.
Potential growth is a function of the estimated growth inhours worked and how much output per hour can be produced, whichitself is linked to the amount of machinery they have to workwith. The “more-intense challenges in the energy sector” is themain driver of a softer outlook for productivity through 2021,the Bank of Canada said in its monetary policy report.
Strong increases in immigration and non-permanentresidents, which boost labor's contribution to the Canadianeconomy's speed limit, aren't enough to offset this dynamic.
The combination of lower potential growth and neutral ratesare the latest manifestation of the “serial disappointments”from global activity Poloz has long lamented, which havecontributed to slower than anticipated Canadian exports andcapital spending during his tenure.
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