What the Bank of Canada didn’t say speaks volumes

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There's just one obstacle left in the road to the Bank of Canada's first interest-rate increase since 2010, but it's the biggest one of all: the gaping hole where inflation is supposed to be.

The central bank's latest rate announcement issued Wednesday, as tame as it appeared on the surface (highlighted, if you can call it that, with the decision to hold the key rate unchanged for the 15th straight time), struck a notably upbeat tone for those well-attuned to the subtleties of central-bank-speak. While it was far from unqualified enthusiasm for Canada's economic recovery, the brief statement quietly turned some of the bank's most persistent frowns upside down.

Most notably, the BoC declared the economy's long adjustment to the 2014 oil price collapse "largely completed."

Read more: Bank of Canada leaves key rate unchanged

The declaration on oil prices brushes away the last vestiges of a painful economic transition that tainted the bank's outlook for two and a half years. Business investment, whose slump had strangled economic growth, is now "encouraging."

The housing sector was described not as a regional danger, but rather as a source of increasingly broad-based strength supported by a strong job market. Government policy measures aimed at the housing market, while not yet having much of a cooling effect, are nevertheless "contributing to more sustainable debt profiles," which has always been the more important part of the housing equation for the central bank.

Yes, the bank continued to worry about export growth, calling it "subdued" and blaming Canada's "ongoing competitiveness challenges." But with exports up a strong 7 per cent annualized in the first quarter, with a lower Canadian dollar, and with stronger projected U.S. and global growth on the horizon, this one note of negativity sounds a bit misplaced. (Perhaps the competitiveness concerns more reflect the bank's worries about the uncertainties of protectionist U.S. trade policy than they do about the generally positive trend in the export data.)

A couple of the biggest turns toward the positive came in things that the rate announcement, conspicuously, did not say. In its previous statement, in mid-April, the bank said it was "too early to conclude that the economy is on a sustainable growth path"; that glass-half-empty skepticism has been expunged from the latest statement. The bank also dropped its practice, in each of the previous four rate statements, of specifically contrasting the near-full-capacity U.S. economy and the "material slack" in the Canadian economy.

It can be dangerous to read too much into the words that aren't there, but one inference from all this is that the Bank of Canada, albeit tentatively, is clearing the route to an eventual rate increase. It appears more confident that the impressive growth of the past three quarters is part of a sustainable trend. It sounds more sure that the economy is absorbing its excess capacity – a key to eventual rate increases.

But it's probably no accident that the Bank of Canada moved its discussion on inflation to the top of the rate statement, up from near the bottom of the April announcement. With other factors moving aside, this is the key obstacle blocking the view to a rate hike.

Remember that the Bank of Canada uses an inflation target (2 per cent annually) as its formal guide to setting rate policy; that's because inflation has, historically, served as a fairly reliable barometer to a hot economy in need of higher rates to cool its jets. Ultimately, an inflation rate pressing up against the target will be what triggers a rate increase. But despite the increasingly positive economic signals, inflation isn't following; indeed, it has actually been drifting further away from the target.

The bank figures at least some of the weakness in inflation is temporary – it says "intense retail competition" has been depressing food prices. Still, the central bank's three gauges of core inflation – which each aim, in different ways, to eliminate this sort of temporary noise and hone in on the underlying inflationary pressures in the broader economy – are averaging just 1.4 per cent, very much at odds with the otherwise brighter economic picture.

At the root of the inflation malaise is a stubborn lack of wage growth in the economy. Despite continued solid employment growth, weekly wages have barely moved over the past year, according to Statistics Canada's April labour force survey. Wages showed little momentum in the first quarter, despite what looks to have been one of the strongest quarters of economic growth in years. (The first-quarter gross domestic product figures will be released next week.)

To the Bank of Canada, this lack of wage growth is much more than a curiosity or a nuisance; it's a smoking gun for the "ongoing excess capacity in the economy."

That's probably the most important phrase in this otherwise quite-positive rate announcement. As long as wages remain stuck in neutral, it's unlikely the bank will be convinced that inflation is sustainably headed for its 2-per-cent target – and just as unlikely that the brighter economy will translate into a rate hike.

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