Bank of Canada in a rush to remove accommodation

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The Bank of Canada has reversed the rate cuts of early 2015 in quick succession. While it will likely remain on a tightening course, we expect the pace to slow significantly.

In a surprise move, the Bank of Canada (BoC) raised its policy rate for the second time in only two months, to 1.0% from 0.75%. Given low imminent pressure to tighten policy, we had only expected the BoC to hike next at the upcoming October meeting. The BoC mainly argued that the stronger-than-expected growth performance of the Canadian economy so far this year would warrant “removal of some of the considerable monetary policy stimulus.” This comes against a backdrop of still weak inflationary pressure and remaining labor market slack, facts that the BoC explicitly acknowledged in its accompanying statement.

Now that the BoC has fully reversed the rate cuts of early 2015 and moved the policy rate to almost US levels, we believe the hurdle for further rate hikes has become higher. The BoC itself did not include an explicit policy bias and mentioned that future decisions will be data dependent, with a particular focus on labor market conditions. Even though we expect the latter to improve further, headwinds are building up. First, growth is very likely to slow from its extraordinarily strong H1 pace.
Second, the significant currency depreciation is likely to limit the recovery in inflation, especially as we move into next year (CAD appreciation tends to have a few-months lag until it feeds into underlying inflation). As such, we expect the Bank of Canada to pause for the rest of the year, though the apparent readiness to also surprise on the hawkish side indicates that risks around the rate outlook remain tilted toward that direction.

Other data highlights

  • USA, FISCAL POLICY: According to news reports, the White House and Congressional leaders yesterday agreed to extend the debt ceiling and fund the government through a continuing resolution until 15 December 2017. The measures are planned to be passed together with a bill to provide financial aid (USD 7.85 billion) to victims of Hurricane Harvey. The decision removes an important risk factor for the US Federal Reserve’s likely decision at the 20 September meeting to announce the start of shrinking its balance sheet. At the same time, the new deadline will be just two days after the 13 December Fed meeting.
  • GERMANY, FACTORY ORDERS: New manufacturing orders declined 0.7% MoM in July, following a 0.9% MoM gain in June. All major components weakened, with domestic capital goods orders falling the most (-5.1% MoM). So called core goods orders, which exclude volatile transportation equipment orders, held steady in July. Despite the slight softening of headline new orders, the robust growth picture of the German economy remains little changed, in our view. Business surveys remain at very high levels and recovering growth abroad, particularly in major emerging markets, should offset the recent appreciation of the euro.
  • AUSTRALIA, GDP: As expected, GDP growth in Australia rebounded in Q2 from its subdued Q1 levels, to 0.8% QoQ from 0.3% QoQ. The main drivers were stronger consumption, recovering business investment and a positive net exports contribution. Still, underlying growth dynamics are rather lackluster and likely to remain at around potential at best. The main constraints are relatively weak household income growth on the consumption side and the slowdown on the housing market on the investment side.
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