BoC can raise early, but they can’t be early and increase more frequently than the U.S. Fed: BMO CIO
A top Bank of Canada official warned the central bank’s ability to gauge when the nation’s economy has reached full employment, and when interest rates need to rise, has become highly uncertain.
Deputy Governor Lawrence Schembri said policy makers are striving to bring the economy to full capacity with employment at its maximum sustainable level. But measuring that level has become more difficult because of structural changes and the uneven effects of the pandemic on the labor market.
“Our assessment of labor market conditions and underlying capacity and inflationary pressures is now more difficult,” Schembri said in prepared remarks to the Canadian Association of Business Economics on Tuesday. “Consequently, more uncertainty exists around the timing of when the output gap will close and inflation will return sustainably to our 2 per cent target.”
Lawrence Schembri speaks during a Bank of Canada video conference in June 2020.
The Canadian dollar was little changed after Schembri’s speech, trading 0.3 per cent lower at $1.2557 per U.S. dollar as of 1:53 p.m. in Toronto. Yields on Canadian two-year bonds were up 3 basis points from Monday’s close to 1.04 per cent.
The speech represents a reminder to markets that the path to normalization remains fundamentally unknown, contingent on the economic trajectory and health of the labor market. Governor Tiff Macklem gave a similar notice to global investors in an opinion piece Monday for the Financial Times, in which he pointed out that while the timing of the next rate hike is “getting closer” it will be dependent on economic outcomes.
Altogether, the Schembri and Macklem comments represent an effort by Bank of Canada officials to re-emphasize critical elements of their current forward guidance, which is not to raise interest rates before capacity is fully absorbed. At a policy decision last month, the Ottawa-based central bank brought forward the timing of when that’s expected to happen to sometime between April and September. Previously, the bank had been expecting the output gap to close no earlier than July.
The stance was more hawkish than expected and caught some market players by surprise. Investors reacted by raising bets on a more aggressive rate hike path, with markets currently anticipating the Bank of Canada will raise its benchmark overnight policy rate to 1.5 per cent over the next 12 months, from 0.25 per cent now.
Schembri warned on Tuesday that the central bank’s projections could change, and policy moves will be outcome dependent.
“There’s a lot of uncertainty about the timing of the closing of the output gap,” Schembri said, in response to a question from the audience. “One should be careful not assuming it’s necessarily going to be Q2.”
Schembri sought to provide some more clarity into how the central bank is thinking about full capacity in his speech, including highlighting the growing uncertainty around measuring it.
The evidence suggests that the labor market has recovered well “but considerable excess capacity remains,” he said, adding that rates of unemployment and underemployment remain elevated for certain groups. He also said the central bank still believes the recent run up of inflation is transitory.
Canada will report inflation data for October on Wednesday. Economists are predicting annual inflation reached 4.7 per cent last month, which would match the highest level in three decades.
Schembri described efforts by the Bank of Canada to look at a wide range of labor market indicators to assess the recovery, including breaking out conditions by age, gender and education. The research found labor-market conditions have improved, but areas of slack continue to be present, he said.