The latest decision by the Bank of Canada to maintain its policy interest rate at 2.25% has stirred discussions in financial markets, with some experts predicting potential rate hikes in the coming year. This move, which follows a rate reduction in October, is seen as a strategic step to keep inflation close to 2% while aiding the economy through its period of structural adjustment.
Bank of Canada’s Strategic Rate Decisions
Despite a drop in the second quarter’s gross domestic product and a weak labour market, the bank was firm in its stance on maintaining the current policy rate. The bank’s statement indicated that if inflation and economic activity evolve in line with the October projection, the current policy rate would be the right level to keep inflation close to 2% while helping the economy through this period of structural adjustment. Since then, the data has been stronger than expected, justifying the bank’s decision to remain on the sidelines.
Interpreting the Economic Data
The third-quarter GDP grew at an annualized rate of 2.6%, exceeding market and bank projections of 0.5%. However, this growth was mainly driven by a substantial drop in imports, which automatically increased GDP as net exports increased. A fall in household consumption indicates a less positive economic situation. The bank is still assessing what the data revisions mean for the likely path of inflation.
GDP and Inflation
While it’s true that the realized GDP was higher than expected, it doesn’t give any indication about potential GDP, which reflects what the Canadian economy is capable of producing at full employment. The output gap, the difference between actual and potential GDP, affects inflation. The stubbornness of core inflation, with Consumer Price Index-trim at 3% and CPI-median at 2.9%, suggests that the economy’s potential is unchanged, and that the higher actual GDP was responsible for keeping price growth elevated.
Labour Market Observations
The latest Labour Force Survey showed surprising strong employment growth in November, with the economy adding 54,000 jobs and causing the unemployment rate to fall by 0.4 percentage points to 6.5%. However, this increase was driven by the addition of 63,000 part-time jobs, meaning full-time jobs fell by around 9,000. Despite these positive results, the unemployment rate remains elevated compared to July 2022, suggesting there is still some slack in the labour market.
Looking Forward
Currently, the bank’s policy rate is at the bottom end of its estimated range for the neutral rate, which is the rate compatible with inflation at the 2% target and the economy at full employment. Given the positive data surprises, but paired with what we see as underlying weakness, the lower end of the neutral rate range seems appropriate. The bank is likely to remain on the sidelines well into the new year, as long as headline inflation continues to hover around the 2% target. The direction of rates could go either way, with arguments for both rate hikes and cuts.
