When Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, gave an upbeat review[1] of the economy earlier this week, currency and bond markets started to factor in a rate hike. The Canadian dollar jumped  just over 1 per cent and the 10 yr bond yield backed up about 10 bps. Her comments have been interpreted as a major shift in policy towards tightening.  Are these markets reading too much into Wilkins’ statement?

To begin with, Wilkins argued that Canada is experiencing a “more broad-based economic growth which makes it more likely that it will be sustainable over the medium term.” Furthermore, the Bank sees signs that the adjustment to much lower oil prices is now well underway and that should lead to an improvement in capital expenditures. Business investment has been very poor since oil prices collapsed in 2014 and that has been a major drag on economic performance. Overall, the Bank is encouraged by growth in several important sectors as well as a general improvement in job creation.

Traders should not, however, lose sight of the key factor that determines rate policy: namely inflation and inflationary expectations. Wilkins was quick to point out that: “While broad-based growth is desirable, it’s not under the direct control of monetary policy, and it’s not our objective. We target a 2 per cent inflation rate.”

In fact, the Bank aims to contain inflation in the 1 to 3 per cent range. As the accompanying chart shows, the total CPI is 1.6 per cent i.e. in the middle of the target range. Inflation would have to move up considerably to provoke the Bank to withdraw current monetary stimulus.

The primary reason that inflation remains low is that there continues to be a significant “output gap”; that is total resources—labor and the capital stock--- are not fully utilized. Until that the output gap is much closer to being closed, inflationary pressures will be subdued. Wilkins makes it clear that: “slack in the economy is still translating into below-target inflation and hence the risks to the outlook remain”.

A closer look at the speech turns up additional caveats that clearly temper the Bank’s need to raise rates. As Wilkins points out, “higher –than expected spending, if funded by credit, could add to the vulnerabilities in the household sector.”

In other words, the Bank is very concerned that any rate hike will lead to a serious downturn in the housing market. She also noted that “ if there was one disappointment in the first quarter figures, it was exports.”

Again, the Bank is not about to do anything that will jeopardize exports, especially in today’s protectionist environment.

It is unlikely that the Bank will switch gears and move in the direction of tightening monetary policy any time soon. In some ways, the Bank is, for the moment, enjoying some relief from the past pressures of falling oil prices, weak employment growth and very low inflation rates. A lot more evidence of sustainable growth and inflationary pressures are needed to move the Bank in a new direction.

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