Show Transcript
The Bank of Canada defies market expectations holding its key rate steady, but ratchets up its inflation outlook. Anthony Okolie speaks with Alexandra Gorewicz, Portfolio Manager, Active Fixed Income, TD Asset Management, about the BoC’s decision and the outlook for rates.
Print Transcript
- The Bank of Canada kept its key overnight rate steady in a move that surprised many. Alex, you actually expected them to hold. Why do you think they did that?
- A couple of reasons, Tony. The first thing that we expected Omicron to take a bite out of economic activity. And in fact, the bank does cite that they expect there to be an impact to Q1 GDP, although a lesser impact than prior waves of the pandemic. And the second reason is that we expected them to publish revised forecasts around their expectations on when the output gap would close, on how inflation might evolve throughout the year. And for those reasons, we thought that they would remain on hold, but perhaps indicate when they thought it was appropriate to raise rates.
- Is this a hawkish hold which kind of prepares us for lift off at the next meeting?
- I like the way you put that. Yes, we would think that now that conditions have been met, in fact, the Bank of Canada believes that economic slack has been absorbed. And so we can see an interest rate hike in March. But I think even more important than that for monetary policy in 2022 will be what happens to the balance sheet. They have indicated that once they begin to raise interest rates, they could consider reducing the balance sheet and that could be another avenue for monetary policy tightening this year.
- And how many rate hikes are you expecting this year? And where does that leave rates by the end of 2022?
- So I'll put a range-- it could be three rate hikes, it could be four rate hikes. And I think part of that is dependent on how they do begin reducing and how quickly they reduce the balance sheet. But we expect in general, in interest rate hikes, the bank to be more cautious.
For example, coming into this meeting, the market in general believed that the Bank of Canada would hike interest rates five or six times to the end of 2022, and we didn't see that as a possibility for two main reasons. The uncertainty with a prolonged pandemic or lingering pandemic has told all of us-- investors, economists, monetary policymakers-- that we need to have wider error bands around our economic projections.
And then the second reason is the bank believes that the neutral interest rate that keeps the Canadian economy in equilibrium in the long run is possibly lower than where it has been in the past. And if that's the case, the number of interest rate maneuvers that it has in its toolkit is probably lower. So they'd be more cautious on how they deploy that.
Now, we do expect interest rates to rise, as I have said. And so we believe shorter maturity yields will rise in accordance to what the bank does. But we believe longer maturity yields will rise less, if at all, because of that lower neutral interest rate. And so we expect interest rates to rise but the yield curve to flatten.
- OK, let's touch on inflation. The Bank of Canada also ratcheted up its inflation outlook higher. What's your view on where it's headed and how much of a headwind will it be?
- So that's an excellent question. This is really the million dollar question on how quickly that-- call it smaller arsenal of rate hikes is deployed by the bank. A big risk is that we get a new variant-- one that could be as disruptive as Omicron, perhaps even more so. And that would prolong disruptions in global supply chains and even disruptions in labor market closer to home, both of which we know have good reasons for why inflation has remained stubbornly high and above the bank's projections.
And although the Bank of Canada does believe that inflation will fall towards the top end of its inflation target range-- it now believes about 3% to the end of the year-- that number was revised almost a percent higher, and in large part because we've been reminded that we're still in the pandemic. So another wave should probably put upward pressures on those inflation projections.
And we don't see that at the moment, but, of course, again, uncertainty suggests we should be cautious. And so we expect inflation to remain elevated this year.
- Now, after the decision, we saw the loonie lost a little bit of its momentum. How do you expect the loonie to perform going forward?
- So I think it's important to note that a few factors play on the Canadian dollar, particularly against the US dollar-- economic growth projections, real rate differential, so what the central banks do, and then commodity prices-- oil specifically. Now, our outlook on oil is extremely constructive for 2022, which gives the Canadian dollar an advantage not just against the US dollar, but against major market currencies.
And so we do expect the Canadian dollar to appreciate. But some of the other factors I mentioned should actually see the Canadian dollar move plus or minus in a tight range around the US dollar, given that we expect monetary policy to unfold at a relatively steady pace between the two banks and that we expect economic developments around GDP and around inflation to evolve again at a very similar pace between the two economies.
So then oil will be the ultimate determinant. And if the Canadian dollar on average in 2021 traded at $0.80 versus the greenback with, call it, a couple of cents range around that, we expect that range to be higher but equally tight this coming year.
- Alex, thank you very much for joining us today.
- Thank you very much, Tony.
[MUSIC PLAYING]
- A couple of reasons, Tony. The first thing that we expected Omicron to take a bite out of economic activity. And in fact, the bank does cite that they expect there to be an impact to Q1 GDP, although a lesser impact than prior waves of the pandemic. And the second reason is that we expected them to publish revised forecasts around their expectations on when the output gap would close, on how inflation might evolve throughout the year. And for those reasons, we thought that they would remain on hold, but perhaps indicate when they thought it was appropriate to raise rates.
- Is this a hawkish hold which kind of prepares us for lift off at the next meeting?
- I like the way you put that. Yes, we would think that now that conditions have been met, in fact, the Bank of Canada believes that economic slack has been absorbed. And so we can see an interest rate hike in March. But I think even more important than that for monetary policy in 2022 will be what happens to the balance sheet. They have indicated that once they begin to raise interest rates, they could consider reducing the balance sheet and that could be another avenue for monetary policy tightening this year.
- And how many rate hikes are you expecting this year? And where does that leave rates by the end of 2022?
- So I'll put a range-- it could be three rate hikes, it could be four rate hikes. And I think part of that is dependent on how they do begin reducing and how quickly they reduce the balance sheet. But we expect in general, in interest rate hikes, the bank to be more cautious.
For example, coming into this meeting, the market in general believed that the Bank of Canada would hike interest rates five or six times to the end of 2022, and we didn't see that as a possibility for two main reasons. The uncertainty with a prolonged pandemic or lingering pandemic has told all of us-- investors, economists, monetary policymakers-- that we need to have wider error bands around our economic projections.
And then the second reason is the bank believes that the neutral interest rate that keeps the Canadian economy in equilibrium in the long run is possibly lower than where it has been in the past. And if that's the case, the number of interest rate maneuvers that it has in its toolkit is probably lower. So they'd be more cautious on how they deploy that.
Now, we do expect interest rates to rise, as I have said. And so we believe shorter maturity yields will rise in accordance to what the bank does. But we believe longer maturity yields will rise less, if at all, because of that lower neutral interest rate. And so we expect interest rates to rise but the yield curve to flatten.
- OK, let's touch on inflation. The Bank of Canada also ratcheted up its inflation outlook higher. What's your view on where it's headed and how much of a headwind will it be?
- So that's an excellent question. This is really the million dollar question on how quickly that-- call it smaller arsenal of rate hikes is deployed by the bank. A big risk is that we get a new variant-- one that could be as disruptive as Omicron, perhaps even more so. And that would prolong disruptions in global supply chains and even disruptions in labor market closer to home, both of which we know have good reasons for why inflation has remained stubbornly high and above the bank's projections.
And although the Bank of Canada does believe that inflation will fall towards the top end of its inflation target range-- it now believes about 3% to the end of the year-- that number was revised almost a percent higher, and in large part because we've been reminded that we're still in the pandemic. So another wave should probably put upward pressures on those inflation projections.
And we don't see that at the moment, but, of course, again, uncertainty suggests we should be cautious. And so we expect inflation to remain elevated this year.
- Now, after the decision, we saw the loonie lost a little bit of its momentum. How do you expect the loonie to perform going forward?
- So I think it's important to note that a few factors play on the Canadian dollar, particularly against the US dollar-- economic growth projections, real rate differential, so what the central banks do, and then commodity prices-- oil specifically. Now, our outlook on oil is extremely constructive for 2022, which gives the Canadian dollar an advantage not just against the US dollar, but against major market currencies.
And so we do expect the Canadian dollar to appreciate. But some of the other factors I mentioned should actually see the Canadian dollar move plus or minus in a tight range around the US dollar, given that we expect monetary policy to unfold at a relatively steady pace between the two banks and that we expect economic developments around GDP and around inflation to evolve again at a very similar pace between the two economies.
So then oil will be the ultimate determinant. And if the Canadian dollar on average in 2021 traded at $0.80 versus the greenback with, call it, a couple of cents range around that, we expect that range to be higher but equally tight this coming year.
- Alex, thank you very much for joining us today.
- Thank you very much, Tony.
[MUSIC PLAYING]
