BoC Hike Months in Making

Stephen Poloz couldn’t hold off raising interest rates any longer.

Economists are predicting the Bank of Canada governor will resume tightening policy this Wednesday in what would be the first increase in borrowing costs since January. More hikes are set to follow as firms warn of wage pressures and inflation remains above the central bank’s target.

Poloz, however, is still unlikely to be in a hurry. There remains a long list of reasons for prudence, starting with the real possibility Canada gets into a trade war with its biggest trading partner. And if the recent past is any indication, the Bank of Canada’s tendency will be to default to caution and wait for data to force its hand -- a framework most analysts expect will produce a rate hike every half year or so.

The hyper data-dependency reflects in large part the emphasis Poloz places on uncertainty in policy making -- everything from geopolitical tensions to questions about the reliability of economic forecasts. That means, in Poloz’s parlance, not following models mechanically, using a "risk management" approach to decision making and placing a high value on incoming economic data.

Right now, though, the accumulated data since the last hike in January is too compelling to ignore.

Inflation has slowly marched above the central bank’s 2% target and is heading higher. The unemployment rate is near the lowest in four decades, and executives are more likely to complain about labor shortages than lack of business. Wages have been accelerating. Exports and investment -- the big disappointments over the past decade -- are finally looking healthy, which lessens the economy’s reliance on consumers and makes the expansion more resilient.

Of 18 economists surveyed, 14 were expecting the Bank of Canada to raise its benchmark rate by a quarter point this week to 1.5%. Market pricing is in line, with investors placing odds of more than 80% on a hike at Wednesday’s decision, which includes a fresh economic forecast and press conference.

After that, it’s expected to be a bit of crawl. Odds of another hike by the end of this year are only 50-50 and no more than three hikes in total -- including the one this week -- are priced in over the next 12 months, which would bring rates to 2%. Chances of hikes beyond that are deemed slim.

If the market is right, that would sill leave rates well below what is considered normal -- the Bank of Canada estimates its neutral rate at no less than 2.5% In other words, gradualism will persist.

Policy normalization is a delicate task. Interest rates are still very low and the Canadian dollar has weakened, providing extremely accommodative financial conditions. In real terms -- adjusted for inflation -- the official benchmark rate is among the lowest in the world, according to estimates from experts.