Canadian Manufacturing

BoC missed opportunity to mitigate oil-price fallout

HSBC economist says oil-price shock might be larger than the Bank of Canada anticipates

TORONTO—The Bank of Canada left its policy rate at 0.75 poer cent, as expected, and referred to the current degree of policy stimulus as “still appropriate.”

The Bank also provided little in the way of forward guidance, though it did state that impact of the oil price shock might be more front-loaded than anticipated in the January Monetary Policy Report. We still see the need for further policy stimulus, but future actions will depend on forthcoming data on inflation, employment, exports to the U.S., and business confidence in the U.S. and Canada.

In leaving rates unchanged, the Bank of Canada did not provide much in the way of forward guidance. That is, they provided few clues as to future policy moves. That said, the overall statement and the comment that “the current degree of monetary stimulus is still appropriate,” suggest that the Bank will have to see clear evidence of the negative impact of weak oil prices and mounting signs of downside risks to the inflation profile and financial stability to take further easing steps.

The Bank missed an opportunity in leaving rates unchanged. Given that we expect GDP growth to average 1.1 per cent annualized in in the first half of 2015 versus the Bank of Canada’s projection of 1.5 per cent, we still see the potential need for further stimulus. In our view, further rate cuts would bridge the gap between the negative impact of the oil price shock in 2015 H1, and the eventual step-up of non-energy exports and investment in 2015 H2. We expect that the US economy will exhibit only moderate growth in 2015, with the Federal Reserve waiting until September to raise policy interest rates.

We agree with the Bank that the negative impact from the decline in oil prices “may be more front-loaded,” than had been anticipated, but we are less convinced that non-energy exports and investment will be able to provide much of a cushion in the first half of the year.

Forthcoming data on inflation, employment, exports (particularly to the US) and business sentiment in both Canada and the United States will provide real time indications as to the impact of the oil price shock on the economy, and the performance of non-energy exports and investment. We will be closely watching relevant data releases ahead of the 15 April Bank of Canada rate decision and Monetary Policy Report. Consistent with a “front-loaded” impact of the oil price shock, recent evidence for February has pointed to a reduction in activity in the factory sector and a sharp deterioration in small business sentiment. To us, these preliminary indicators highlight a degree of caution in the economy overall, and that it is far from clear that non-energy exports and investment will do much to cushion the blow of the oil price decline.

In today’s statement, the Bank noted that “financial conditions have materially eased since January.” The policy rate is 25 basis points lower than it was prior to the 21 January rate cut, and USD/CAD has moved from below 1.20 to above 1.24. The Monetary Conditions Index, which is an amalgam of a short-term interest rate and a trade-weighted Canadian dollar, did drop on 21 January, but it had been declining since mid-2014, and has been stable since 21 January. Lower values of the MCI reflect easier financial conditions though it is no longer considered an official input into Bank policy decisions.

Meantime, the Bank of Canada’s Financial Conditions Index (FCI) is little changed. It was at 1.31 prior to 21 January, and is currently at 1.29. The FCI is an index that is calculated and is composed of the policy rate, the 10-year bond yield lagged one-quarter, the S&P TSX relative to GDP, housing prices lagged one-quarter, a corporate bond spread, and the real exchange rate lagged two quarters. Higher values of the FCI imply more stimulative conditions.

The MCI thus captures the weakness of the Canadian dollar since the Bank’s surprise rate cut on 21 January, while the FCI does not. Moreover, the FCI indicates that financial conditions have tightened since the fall of 2014. That said, the construction of the FCI does suggest that the most recent bout of Canadian dollar weakness will help boost the economy in 2015 H2.

The Bank of Canada has indicated that the impact of the oil price shock might become evident somewhat earlier than they had initially anticipated. We believe that the shock might also be somewhat larger than the Bank anticipates. We also see risks that exports to the U.S. will face headwinds and rise at a more moderate pace than the Bank expects. Hence, we still anticipate evidence to highlight the need for further easing steps to manage the risks facing the economy and to ensure that non-energy exports and investment are capable of lifting economic growth later this year.

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