Will Canada hike interest rates ahead of the US again?

The Canadian economy has been resilient to the third coronavirus wave with domestic fundamentals remaining robust. GDP is now at 98.5% of where it was in February last year and the country is on track to fully recover GDP lost to the pandemic by the third quarter, as prospects for further economic strength are good.

The vaccination rate has risen rapidly and is likely to lead to a large fall in new cases and the easing of restrictions. The country has now fully vaccinated more than 60% of its population, surpassing the US and the UK vaccination rates for Covid-19.

Vaccine success is boosting confidence in the economy

An accelerating vaccine rollout is boosting confidence in the recovery. This is highlighted by the latest Business Outlook Survey from the Bank of Canada (BoC) that points to continued improvement in business sentiment.

The bank’s composite gauge of business sentiment rose to 4.2 in the second quarter, reaching its highest level on record. Firms are becoming more optimistic that sales will pick up as vaccination rates rise.

The speedy vaccination progress is also supporting the consumption side of the economy, with consumer confidence also close to record highs. This bodes well for the economic recovery in the second half of the year, as it suggests that the reopening will allow households to spend excess savings, releasing pent-up demand.

As households are likely to be less cautious, consumption is expected to lead the rebound with an increase in spending especially on services such as transportation, recreation, and food and accommodation.

Thanks to the generous federal economic support, Canadians have accumulated a large amount of savings during the pandemic. The household savings rate is currently trending at 13% of nominal disposable income, well above its pre-pandemic level of 2%.

As shown in chart 3 below, after the significant drop at the beginning of the pandemic, household spending has swiftly recovered and is now less than 3% below its pre-pandemic level. More importantly, household disposable income is over 10% higher than levels reported in late 2019, supported by government transfers to households.

This suggests that household balance sheets are in good shape, with Statistics Canada reporting that since the start of 2020 households have added over $2 trillion in wealth, also helped by rising house prices.

Housing market sales are near record-high levels as the demand for larger homes with additional space for a home office has increased as more people are working from home. House prices have risen 13% since the start of the pandemic and are likely to remain supported by strong demand and historically low mortgage rates in the near term.

The labour market continues to improve

The labour market is also likely to provide support to Canadian households. Firms’ employment intentions are at record-high levels. Most businesses across all regions and sectors plan to hire, suggesting that a further improvement in the labour market is on the cards.

The country has almost fully recouped the jobs lost amid the pandemic, with employment now only 1.3% below the pre-pandemic level. With reopening gathering pace, by year-end the labour market can recoup the 250,000 jobs needed to go back to the pre-pandemic level of employment.

July’s labour report also highlights that most of the recent increase in employment came from the full-time category, providing strong evidence that the economy is healing after the third wave of the Covid-19 virus.

In addition, the labour market recovery is now broadening to the service-sector, with most of the employment gains recorded in accommodation and food services, a reflection of the lifting of pandemic restrictions.

Labour demand in the service sector is set to pick up further as Canada starts to open its borders to tourists for the first time in 16 months. Given the success of the vaccine rollout, starting from August, fully vaccinated US citizens and permanent residents living in that country will be able to visit Canada without having to quarantine for two weeks.

Visitors from all other countries will be allowed in September. The tourism industry, that accounted for about 2% of Canada’s GDP and generated about 750,000 jobs in 2019, has been partially supported by domestic demand.

The sector, however, is now going to get an added boost from easing border restrictions, adding strength to the recovery in the second half of the year.

Job gains are also likely in another key sector of the economy. Oil and gas extraction is an important contributor to the Canadian economy, especially in Alberta, Newfoundland and Labrador. From the year 2000 onwards, its GDP share of the economy averaged about 5% for Canada.

The oil and gas sector in Canada was badly hit in 2020. First by the oil price crisis in March and April, and then by a sharp decline in global demand on the back of travel restrictions.

As shown in chart 5 the drop in crude oil exports at the beginning of the pandemic was much sharper than the decline in all merchandise exports. While the value of all merchandise exports recovered within three months, the value of oil exports only fully returned to its pre-pandemic level in March 2021.

Employment in this sector is still 5% below its January 2020 level, but further job gains are likely on the back of rising oil prices that will support activity in the sector (chart 4).

Inflation likely to stay elevated

While the labour market is recovering, measures of wage growth remain subdued as the unemployment rate is still above the natural level. However as the labour market slack created by the pandemic will continue to decline with the reopening, pressure on inflation are likely to rise.

Headline inflation has been above the BoC’s target range for four months, currently running at 3.7% year-on-year, an 18-year high. Much of the upward pressure has come from the energy component of inflation, on the back of a significant base effect in gasoline prices.

The core component is also running hot, mostly on the back of escalating prices for core goods as a result of supply chain disruptions and strong consumer demand.

Shelter price are also on the rise and continued to strengthen in the most recent months on higher underlying costs in the owned accommodation category. Services inflation is likely to increase further as the reopening will support demand in the services sector of the economy.

What does this mean for the Bank of Canada?

To reflect the improving outlook, at its July meeting the BoC continued to taper its government bond buying program, reducing its weekly asset purchases by C$1 billion down to C$2 billion.

Further reductions in quantitative purchases are likely in October, when the bank is set to update again its economic outlook.

At its July meeting, the bank left its policy rate unchanged, noting that the recent rise in inflation is seen as transitory as the bank expects economic slack to be fully absorbed in the second half of next year.

The BoC expects headline inflation to ease back toward 2% next year as the temporary effects from higher oil prices and Covid-19-related bottlenecks dissipate. The bank has committed to keep to hold the policy rate at the effective lower bound until the output gap is closed.

However, we think risks are tilted towards the upside thanks to a very fast vaccination rollout and a strong rebound in the second half of this year mainly led buy higher household spending.

Serial positive surprises to the BoC’s inflation and growth forecasts are likely to trigger a more aggressive monetary tightening and the BoC could start its hiking cycle at its April meeting.

This would not be the first time that the BoC starts the hiking cycle ahead of the Federal Reserve (Fed). Following the two previous recessions, the BoC raised its policy rate ahead of the Fed twice since the start of the new millennium, in 2002 and 2010 (chart 7).

This is because the Canadian economy rebounded more quickly than the US economy after the end of the recessions amid rising commodity prices in the recovery phase of the cycle, triggering a tighter monetary policy in Canada.

Clearly, interest rate differentials are a major driver of currency markets. The Canadian dollar is likely to strengthen further, should the BoC tighten monetary policy once again ahead if its US counterpart.