Will the Bank of Canada hike it’s rates on this coming Wednesday? Some say it should and will. Others think rates should be kept on hold due to heightened uncertainty surrounding negotiations about the North American Free Trade Agreement. So, what will the Canadian central bank do? What should it do?
Do not wait for NAFTA
Although NAFTA negotiations began hitting a succession of obstacles in autumn, business sentiment indicators went only one way… Upwards. The threat to Canada from a US withdrawal is not significant due to the low probability of it actually happening and the actual scale of it’s implications. In the unlikely event that the Trump administration does insist on pulling from the deal, the process of the exit procedure must pass through a messy series of votes in Congress. However, in the immediate term, the following has also happened:
- Inflation has strengthened markedly. Headline inflation hit a 2-year high of 2.1% and the less volatile core Consumer Prices Index (excluding volatile food and energy items) has pushed to 1.7% year-on-year from 1.3% y/y, clearly surpassing the pace of US inflation at 1.5%.
- Employment continues to surprise on the upside. Net jobs creation rose by more than 70 thousands in both November and December, figures not seen in more than 5 years. Meanwhile, unemployment fell for the 3rd consecutive month to reach a +40 year low of 5.70%. Moreover, the sharp rise in hours worked and higher wages means more advances for personal disposable income.
- Wage growth is also surpassing that of the US. Average hourly wages hit a 21-month high of 2.8%, surpassing the 2.5% average in the US.
Removing the factor of USD weakness, the surge of the Canadian dollar has been a textbook case of improving yield differentials, healthy fiscal dynamics and broad advances in energy and agricultural commodities. Considering the 6-9 month lag for monetary policy to trickle down the whole economy, it is more pressing for the Bank of Canada to raise rates this month by 25 bps to 1.25%. This in order to overcome the tremendous easing of financial conditions and boost in commodities, rather than wait for the outcome of NAFTA negotiations, which will require several months and rounds.
In the event of a surprise decision to keep rates unchanged, any bounce towards 1.2580-1.2600 in USDCAD will be seen as temporary and corrective before 1.200 becomes the focus for the 2nd half of the quarter.