September has started with a busy economic calendar in Canada, including data releases on labour, inflation, trade and housing- overall, not much new here. Following suit, the Bank of Canada left its target for the overnight rate at 1.5% at its September 5, 2018 meeting, after hiking four times since the beginning of last summer.

Essentially in line with market expectations, the accompanying statement reiterated a “gradual,” data-dependent approach to raising interest rates, and highlighted ongoing NAFTA negotiations as a specific area of concern.  Perhaps more surprising, were remarks the following day by Senior Deputy Governor Carolyn A. Wilkins, noting internal discussions over whether the gradual approach to raising interest rates is still appropriate. Taking this as an indication of potential acceleration in interest rate hikes, the Canadian dollar bounced higher in response.

Fundamentally, the Bank’s mandate is to conduct monetary policy to promote the economic and financial well-being of Canadians. In order to support its mandate, the Bank is targeting inflation at 2% to foster confidence in the value of money and to contribute to sustained economic growth.

In the current context, with the Canadian economy essentially operating at capacity, one could argue that a less gradual approach to raising interest rates to “neutral” levels could be justified. The Bank estimates this neutral rate to be between 2.5% and 3.5%, still at least a full percentage point above the current target.

However, as we look ahead, there are issues that may warrant caution, including stretched consumers and ongoing uncertainty over trade. These may slow economic activity over the coming quarters – and hence support the current, more gradual approach.

Global Economic Activity and Canada's Non-Commodity Exports

Chart shows how Canada's non-commodity exports are falling along with the Purchasing Managers Index, which measures the strength of the manufacturing sector. This illustrates that Canada needs to increase its economic competitiveness in the non-commodity sector

For some time now, the Bank has pointed to the importance of shifting demand from consumption to investment and exports, and recent GDP data has given some favourable indications. However, looking at the business sector’s slowing intention to invest, despite ongoing capacity pressures, we may not have fully turned the corner on more balanced economic growth. Ongoing uncertainty around trade relationships certainly isn’t helpful in this regard. We’ll see whether the fog lifts as Foreign Affairs Minister Freeland reportedly leaves the most recent negotiations in Washington to brief Prime Minister Trudeau in person.

It has been fashionable to assume that, in the case of trade disruption and increased protectionism, we’d see the Canadian dollar depreciate to restore domestic competitiveness. However, the Bank’s response in such a scenario is not necessarily straightforward, as Wilkins outlined in her remarks. In particular, while she acknowledged downside risks to growth, she pointed to potential upside pressure on inflation, and reiterated the Bank’s commitment to price stability.

While a depreciating currency may support economic activity, it may also introduce inflationary pressures through more expensive import prices. It may also increase the risk premium that foreign investors demand to allocate funds to Canada. As we reflect on this in the context of the Bank’s mandate, we may see a less accommodative monetary policy response to lost competitiveness, and by extension greater need for fiscal and regulatory changes to support economic activity.

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