Emboldened Bank of Canada to step up pace of rate rises

LONDON (Reuters) - The Bank of Canada will raise interest rates three times next year, although a firm majority of economists in a snap Reuters poll said it would hold fire at its December meeting.

A cyclist rides past the Bank of Canada building, Ontario, Canada, July 11, 2018. REUTERS/Chris Wattie

Now that Canada’s trading arrangements with the United States and Mexico have been signed into a deal and a great uncertainty lifted, the BoC made clear at its October meeting the economy does not need more stimulus.

Not only did the central bank drop the word “gradual” from its policy guidance on rates but also said it needs to get the overnight rate, now at a decade high of 1.75 percent, to neutral sooner rather than later.

The latest Reuters poll of 26 economists taken Oct 26-31 concludes that the overnight rate will reach the bottom end of what the BoC deems the neutral range of 2.50-3.50 percent by the end of next year. The previous Reuters poll had rates at 2.25 percent by end-2019 and no clear consensus for further rises.

Five of 26 economists forecast a rate rise to 2.0 percent at the December meeting. Financial markets are currently pricing in a roughly one-in-three chance of that happening.

“The BoC seems to have redefined their ‘gradual approach’ to mean that tightening every second meeting might be insufficient to prevent inflation from accelerating. BoC officials thus appear more worried than this summer about falling behind the curve, a profound shift in the market’s mindset in our view,” noted Sebastien Lavoie, chief economist at Laurentian Bank.

“This means that, if the current positive economic momentum holds and geopolitical and trade tensions do not generate excessive market jitters, another hike at the December 5th meeting cannot be ruled out and might in fact be expected.”

Indeed, policymakers have made clear each meeting is now “live” and if economic data justify higher rates by the first week of December, nobody will have the right to claim a rate rise came as a surprise.

The new rate path predicted by the Reuters poll brings the BoC more in line with expectations for the U.S. Federal Reserve, which is also likely to raise the federal funds rate three times next year.

The Canadian dollar, which rallied half a cent on Oct 24 after the BoC’s decision to raise rates and provide new guidance, is trading more firmly as a result.

A majority of economists who answered additional questions in the poll broadly agreed with the central bank’s latest views on growth and inflation.

In the most recent Reuters survey on the Canadian economic outlook, taken a few weeks ago, inflation was forecast to remain above the BoC’s 2 percent target throughout the forecast horizon.

But economists were almost split down the middle in the latest survey on whether the central bank was right to suggest rates may rise faster than they did earlier in the cycle.

The sticking point is over how much debt Canadian households are carrying, most of it attached to mortgages taken out to purchase property during boom times for the housing market.

Canada’s household debt to income ratio was last reported at just under 170 percent, one of the highest in the world, and much higher than in the United States.

“Given the effect on debt service costs, the Bank risks a serious policy mistake if it proceeds at a faster pace from here,” warned Stephen Brown, senior economist at Capital Economics.

Unlike in the U.S., where the last global financial crisis was triggered by falling house prices and resulted in a major correction as well as in household balance sheets, Canada’s housing market, along with debt, has moved up in nearly a straight line.

“We still think highly indebted households’ sensitivity to rising rates warrants a gradual approach to lifting borrowing costs,” noted Josh Nye, senior economist at RBC.

“But with the economy at full capacity and inflation on target, it’s also hard to argue monetary policy shouldn’t be at a more neutral setting.”

Writing by Ross Finley; Polling and additional reporting by Mumal Rathore in BENGALURU; Editing by Chizu Nomiyama