Canada lifts rates, while Yellen sounds dovish.

Red percent symbol inside the symbolic house. The arrow shows the rise and fall of percent. Financial concept

Bank of Canada raised interest rates after seven years: On June 12th, 2017, Bank of Canada raised its overnight lending rate by a quarter-percentage-point to 0.75 per cent from 0.5 per cent, a move taken after seven years. Bank of Canada enhanced the overnight rate to 3/4 per cent while the Bank Rate is correspondingly 1% and the deposit rate is half per cent. The bank believes that major economic slowdown is over, and this happened ahead of their expectations. The bank sees that a major amount of excess capacity in the economy is absorbed. As per the July monetary policy report, the Bank expects that the degree of excess capacity in the economy was between 0 and 1 per cent in the second quarter of 2017, as compared to a range of estimated excess capacity in the range of 1.5 and 2.5 per cent in the prior corresponding period. Moreover, the bank also noted that many labor market indicators are on track with this assessment, indicating that labor market slack is also being absorbed, although with a lag. Recent employment growth is strong while unemployment rate decreased, and the business outlook survey indicates a broad-based tightening in labor market conditions.

Improving economic conditions propelled the rate hike decision: Improving Economic activity in the recent quarters contributed to the raising rates decision. The bank expects near-term growth to remain solidly above the potential growth in GDP in the first quarter of 2017 which picked up strongly to 3.7 per cent. GDP growth is expected to average 2.5 per cent in the second and third quarters and remain above potential output growth. Further, decent household spending and early signs of more balanced trades including recent pickups in exports and business investment boosted the economic activity. Exports and investment rise would continue to add to the projected broadening in the composition of demand, enabling economic expansion offsetting the slowing residential investment and household consumption. As per the bank projections, real GDP is expected to expand by 2.8% in 2017 but decrease to 2.0% in 2018 and 1.6% in 2019. They output gap is expected to close around the end of 2017, earlier than projected in April. Meanwhile, Consumer price index (CPI) inflation has been soft for the most part on the back of food, electricity and automobile prices. The bank expects Inflation to pick up and return close to 2% by the middle of 2018 subjective to the price movements decrease coupled with absorption of excess capacity.


Most of the industries improving performance (Source: June Monetary policy report)

Post effects of rate hikes: After the rate hike, the Canadian dollar increased. Moreover, consumers will now pay more for borrowing like variable-rate mortgages and lines of credit.  Canadians with variable-rate mortgages, also known as adjustable-rate mortgages, would face this rise in the overnight rate. Homeowners with fixed-rate mortgage might not see any change till the fixed term ends. Major big banks in Canada already began charging more for their five-year fixed-rate loans. Most of the Credit cards charge fixed interest rates but some credit cards charge variable interest rates, which will be changed. On the other side, not all have welcomed the rate hike as in the first quarter of 2017, oil and gas drilling rig activity has levelled off, while imports of machinery and equipment activity has slowed. Housing sector activity was impacted by decrease in resales in Toronto and surrounding areas. Consumer spending might also slow to a more sustainable pace as the temporary effect of government transfers and special payments on growth in household disposable income reduces. Despite delivering a strong Motor vehicle sale, they are at an all-time high and are expected to moderate.

Why Yellen is dovish

Economic activity in line with expectations: Economic developments in the United States have been as expected, and accordingly Janet Yellen, Federal Reserve Chair, believes that the central bank could keep raising interest rates. But, the first-quarter of 2017 growth in the US has slowed mainly on the back of transitory factors, like drag from inventories and a weather-related decline in the consumption of utilities (Source: June Monetary policy report by Bank of Canada). On the other hand, there has been an unexpectedly strong and broad increase in business investment, including a sharp rebound in energy investment. Labor income and consumption, are as expected in the second quarter as per the recent data. However, Inflation has been lower than projected with major impact coming from the temporary factors. Job gains growth is on track with the falling unemployment rate. The prospects of expansionary US fiscal policy are less clear as compared to the April, given delays in decision-making processes. But, US economic fundamentals continue to support the projected growth of over 2% over the projection horizon, which is slightly above the projected potential growth of 1 3/4 per cent. Consumption growth should remain firm, sustained by gains in labor income. Solid domestic demand is expected to continue to support business investment while Net exports, in contrast, are likely to remain a source of drag, driven partly by the past appreciation of the US dollar.


Improving investments in US and Canada (Source: July Monetary policy report)

Fed’s argument on interest rate hike: Yellen sounded “slightly more cautious on the inflation outlook”, but intends to maintain their expectation for an ongoing rate hikes and start the initiative to begin reducing the Fed’s balance sheet. Given the steadying U.S. economy, Fed is slowly trying to pull back the stimulus to pump the economy. Based on the recent data from Fed, the Fed balance sheet (weekly change in total assets) declined by $0.6 billion post rising $3.9 billion in the prior week, for the July 12 week. This weekly decrease is mainly on the back of the central bank liquidity swaps which fell $3.0 billion to offset a $2.6 billion rise in other assets. The level of overall assets for the July 12 week reached at $4.467 trillion. Reserve Bank credit for the July 12 week lost by $0.2 billion post falling $4.1 billion in the prior week. Meanwhile, the U.S. expansion is in its ninth year while Fed expects to create jobs without much inflation. Demand for labor is solid and this could be seen in jobless claims which is currently at historic lows. As per Fed, they expect initial claims coming in at 246,000 in the July 8 week as compared to 248,000 in the prior week. As per the recent employment data, unemployment reached 4.4% in June while employers added 187,000 jobs a month on average over the past 12 months.  On the other side, Janet Yellen accepted that there are wage pressures but warned it’s premature to conclude that inflation trends are falling back below 2 percent. But she expects the Fed’s reserves, would be reduced substantially. Therefore, it is their goal to hold only Treasuries on the Fed’s balance sheet (the Fed currently owns $1.8 trillion in mortgage-backed securities). Accordingly, Fed already enhanced the interest rates in June for a second time this year and forecasts another rate hike would be imminent in 2017.


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