Bank of Canada should act cautiously in its quest to raise interest rates

Canadian Economy

The Canadian economy has exhibited substantial momentum during the start of Q1 of 2017, growing at a rapid annualized pace of 3.7%, which moderated but allowed for a healthy momentum to be taken into Q2.  This has resulted in market analyst firms to upgrade their outlook on Canadian economic growth for the current year.  For example, TD Economics has improved its outlook from 2.3% to 2.8%, fastest rate of growth since 2011.  The positive aspect of this phenomenon has been its broad base function, as all major sectors have contributed positively.  While the momentum in the economy would continue to absorb slack, the main challenge is the nascent inflation rate that could most certainly put off the much-anticipated interest rate hike decision by Bank of Canada.

For the central bank, the catchphrase has been ‘slow and steady’, as both external and internal factors have kept them cautious.  For example, NAFTA renegotiations could have a substantial impact given Canada’s heavy reliance on its largest trading partner; further fiscal reforms in the US would be catalytic to the wellbeing or conversely demise of the Canadian economy.   The compounding negative impact of consumer debt, or the rupturing of a potentially harmful housing bubble, are also important factors to consider.  Economic reliance on both these contributors is underscored by the fact that during Q1 consumer, spending remained robust at 4.5% higher than a year earlier and residential investment registered a whopping 15.7% increase, a stalwart performance of the last 5 years.  Also as per recently released data, vehicle sales surpassed 200,000 units in June for the second consecutive month, which is another noteworthy indicator of consumption.  This translates into a robust 6% growth, which then again ripens up the prospect of a rate hike, understood to be instituted as early as October 2017.

Keeping in view the broad-based progress, and rate hike probability heightened, the outlook beyond 2017 for household consumption and residential investment, points to a slowdown.  While restructuring measures to cool down the prospects of an overheated housing market specifically in the Ontario region, rising borrowing costs will become a headwind.  Studies on the effects of macroprudential tightening in Canada suggests that residential investment will experience a small decline during 2018, and support from household wealth will reduce.  Further, as per forecast, consumer spending is to moderate from its current seemingly unsustainable level of 3% to 1.7% in 2018, as employment gravitates to its long-term average of 6.4%.

While consumer spending and real estate have been the mainstay of the Canadian economy after the crude oil meltdown, headwinds in these sectors need diversion in order to avoid hindrance to growth.  -residential business investment has been encouraging, and there has been an uptick in imports: a sector that had been languishing for the last couple of years, with prices charting a recovery.  Further, domestic industries, such as food manufacturing are also contributing effectively to a broadening economic base which points to a sense of durability in the economy.

It is not an overstatement that the Canadian economy remains vulnerable.  For example, renegotiation of NAFTA , a hallmark of North American partnership and prosperity, should also gain a lot of attention during the latter part of the year.  A modernization of agreement has the potential to go either way, and again exposes Canadian economies vulnerability to the international environment, as it would need to keep a close eye on its domestic challenges.


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