The Rate Hike: Are we there yet?

With the Bank of Canada nearing its next policy decision on July 12, governor Stephen Poloz is reiterating the message that his 2015 interest-rate cuts appear to have done their job. Poloz has stated that the Canadian economy has enjoyed "surprisingly" strong growth in the first three months of 2017 and he expects the pace to stay above potential.

The comments fed speculation about a Bank of Canada rate hike next week. Should the central bank increases its key rate, the big Canadian banks will raise their prime rates, driving up the cost of variable rate mortgages, other loans and lines of credit tied to the benchmark rate. Incase you missed it, RBC has hiked rates on its fixed-term mortgages amid rising bond yields and widespread anticipation that the country's central bank will raise its benchmark interest rate next week. The new rates are 2.54 percent, 2.64 percent and 2.84 percent, respectively, for mortgages with amortization periods of 25 years or less.

According to Bloomberg, one-third of forecasters, including CIBC and TD, are sticking to the view that Governor Stephen Poloz will keep the Bank of Canada's key overnight lending rate steady at next week's meeting. The majority of economists (excluding me), 16 of 24, also predict the central bank will lift its benchmark rate to 0.75 percent.
 

The change in consensus has been very rapid as only a month earlier just two analysts predicted rates would rise at all in 2017. So basically Canada has moved from the housing crisis to a rate hike in a matter of days! Now one of the biggest components of a rate hike is the rate of inflation. Yet, not only has inflation been sluggish, it's also weakening. Consumer prices in May were up 1.3 percent on an annual basis – the slowest pace this year. So where's the fire?

In my opinion, the Bank of Canada is looking at its traditional model – based on the historical relationship between inflation and where an economy is relative to its capacity – and expects that inflation will rise above 2 percent in the year ahead. While the models have fallen short in the past, it seems that Poloz isn't ready to only watch and react to the rate of inflation. I'd agree for a rate hike if the Bank of Canada would be willing to tolerate inflation below 2 percent for the sake of financial stability aka managing debt levels. Extremely low interest rates have fueled household debt and that would explain why Poloz didn't cut interest rates further when the economy was weak, and why he's keen to raise borrowing costs now. Should be an interesting next week.