Bank of Canada says economy better able to weather shocks

The Bank of Canada indicated the country’s economy has recovered enough strength to better cope with potential negative shocks, and officials would be willing to defy any global easing if domestic conditions warranted.

In a speech a day after a rate decision in which the Bank of Canada resisted pressure to open the door to monetary policy easing, Deputy Governor Lawrence Schembri said policy makers began their deliberations this week by recognizing the economy had performed better than expected and was probably running at about capacity.

While acknowledging risks to the global economy and the fact other central banks are cutting rates, Schembri said the Bank of Canada will only conduct policy that suits the country’s own economic conditions. These include interest rates that continue to be stimulative, inflation at 2% and high household debt levels.

"The Bank of Canada will continue to conduct monetary policy appropriate to our circumstances,” said Schembri, according to a prepared copy of his speech in Halifax, Nova Scotia. "We will continue to ground our decisions in our policy framework, setting interest rates to achieve our inflation target, mindful of the implications for financial vulnerabilities.”

Schembri’s speech is what the central bank calls its Economic Progress Report, in which it aims to provide insight into deliberations following the rate decisions that aren’t accompanied by new forecasts.

At its decision Wednesday, policy makers left interest rates unchanged for a seventh straight meeting and surprised markets by asserting current levels of stimulus are still appropriate despite the escalating trade war between China and the U.S.

The Bank of Canada’s reluctance to signal a greater willingness to cut rates is making the central bank an outlier as counterparts around the world ease policy. Investors and analysts had expected more dovish language this week, paving the way for some easing later this year. And swaps trading suggests markets are still anticipating the Bank of Canada will be forced to cut rates as many as two times over the next 12 months, starting with one cut this year.

But in his speech, Schembri outlined some of the bank’s rationale for seeming reluctant to show their hand on the matter. The Canadian economic data have surprised positively, and stronger than expected growth in the second quarter means the economy is operating close to its capacity.

"This solid starting point means the economy has a welcome degree of resilience to possible negative economic developments,” Schembri said.

Another factor is that interest rates have already been falling in Canada -- for global rather than domestic reasons. The current policy rate in Canada, which Schembri pointed out is below the U.S. rate, continues to support the economy, he said.

The Bank of Canada also seems to be wary of interpreting the recent drop in global bond yields as an indicator of recession, with inverted yield curves more likely a sign that investors see weaker long-term growth, the central bank official said.

Schembri also spent a lot of time in his speech highlighting how inflation in Canada looks to be well-behaved, and would be expected to accelerate if policy makers allowed the economy to grow faster than its capacity.

Core has been hovering around 2% since end of 2017, which is consistent with estimate that the economy has been operating close to its potential output most of the period, Schembri said.

Highlights

Global central bank easing is leading to lower bond yields and borrowing costs in Canada

Main themes from July have not changed. "We still see ongoing weakness in the global economy and resilience in the Canadian economy”

What’s changed: U.S.-China trade war has gotten worse with slower momentum than anticipated in China, Europe

Inverted yield curve more likely a sign that investors foresee weaker long-term growth, rather than as a sign of future recession

Since July, Canadian economic data have surprised positively

Stronger 2Q growth means the economy was operating close to its capacity

Inflation in Canada has been well behaved

Core has been hovering around 2% since end of 2017, consistent with estimate that economy has been operating close to its potential output most of the period

Bank published evaluation of core inflation measures Thursday that shows they continue to perform well and are strongly linked to the output gap

2% inflation in July consistent with the idea the output gap is essentially closed

Governing Council recognized the data indicate Canadian economy is operating close to full potential and has gotten past earlier soft patch. New underwriting rules are helping to contain financial vulnerabilities

Data show some areas of concern -- weak consumption and drop in business investment

Things could get worse international and deliver a complex shock