Bank of Canada: Walking a Tightrope

On April 21 the Governing Council of the Bank of Canada (BoC) will meet to discuss monetary policy. After the global COVID-19 pandemic necessitated extraordinary interventions by both global central banks and fiscal authorities, many investors believe that the BoC’s April meeting will mark the first developed market (DM) central bank to begin normalizing monetary policy, by announcing a reduction in the monthly pace of government of Canada (GoC) bond purchases. We think the decision, however, like many faced by central bankers, is not so straight forward.

In fact, the bank must weigh the brighter outlook for U.S. growth, which will also support Canada, against more worrisome trends in domestic public health, including the recent rise in new COVID-19 cases and its more contagious, more severe variants. In the end, we think Deputy Governor Toni Gravelle’s recent speech (read the speech here) sent a strong signal that the Governing Council will announce the first reduction in bond purchases in April. We remain cautious, however, of the economic risks of a premature tightening in financial conditions, which could choke the Canadian recovery.

Canadian government bond yields have increased along with global rates, while the Canadian exchange rate has strengthened against the currencies of Canada’s largest trading partners. These tighter financial conditions appear manageable for now against the economic boost generated by elevated trade and oil prices. Nonetheless, domestic and foreign growth can be choppy and uneven after recessions, making a policy approach focused on risk management prudent.

The Canadian outlook is brightening…

The governing council’s updated economic projections, which will be released along with the April monetary policy statement, are likely to reveal a brighter economic outlook for Canada, and include revised guidance for when the economy might sustainably achieve its inflation target.

Several positive developments since the January monetary policy report (MPR) suggest the medium-term growth outlook has improved. Specifically, the U.S. federal government significantly increased spending on COVID-19 relief programs, crude oil prices jumped roughly 30%, and the Canadian economy proved more resilient to the wider virus spread in January.

We estimate that the positive impact on Canadian exports of higher U.S. growth, coupled with elevated energy prices, which will reaccelerate Canadian oil output, will likely contribute 1 to 1.5 percentage points (ppts) to 2021 real GDP growth, lifting it to 6% year-over-year in the fourth quarter (up from 4.6% in January). As a result, the governing council will also likely revise its timing for when the economy will reach its potential, and therefore when inflation is expected to run sustainably at its 2% target from 2023 to mid-2022.