Looking at the Canadian dollar's reaction to Wednesday's Bank of Canada interest-rate increase, it's clear the market was surprised by how quickly the central bank has jumped into this rate-hiking cycle. Investors may also be surprised by how quickly the bank jumps back out.
Some pundits are saying that the rate increase – which wasn't expected until late October – has thrown open the door for imminent further rate hikes to come. This view is clearly shared by traders in the Canadian dollar, which jumped more than a full cent against the U.S. dollar – a massive one-day move indicative of a substantial shift in market thinking.
Yet, other than making the rate increase a few weeks earlier than many had expected, the bank's statement accompanying its rate decision said precious little to support this hawkish view. In fact, the Bank of Canada's rate path may end up looking a lot like the one the U.S. Federal Reserve has taken over the past two years: slow and halting, with substantial pauses between hikes.
If that's the case, then the bank has just created a communications challenge for itself. It may need to get the market's expectations back in the bottle.
To be clear, pretty much everyone agrees that this rate hike was justified. Statistics Canada reported last week that Canada's gross domestic product grew at a stellar 4.5-per-cent annualized pace in the second quarter, adding to an already strong run of growth in the preceding three quarters. Given that the central bank had already raised rates in July, and that subsequent growth had far outpaced the bank's forecast, another rate hike seemed like a lock.
The bank had indicated that it wanted to unwind the two rate cuts it made in 2015 to support the economy during the oil shock, and had done half the job with its rate hike in July. The economy was giving it an open invitation to complete that mission.
Yet, before the rate announcement, the market saw it as no better than a coin toss whether the central bank would raise rates on Wednesday. The sticking point was one of the central bank's communication practices: In short, this wasn't the ideal rate announcement for the bank to explain its decision.
The Bank of Canada makes eight rate announcements a year. Four come with only a brief written statement, as with Wednesday's rate decision; the other four also include the bank's detailed quarterly Monetary Policy Report, complete with economic projections, and a press conference at which the bank's top officials can elaborate on their decision and clear up any misconceptions. The market has grown accustomed to the bank's demonstrated preference to reserve its rate moves for the latter dates, when a much more detailed feast of information is laid out for traders' consumption.
The central bank's decision to raise rates now, rather than wait for the next MPR-and-press-conference opportunity on Oct. 25, speaks to the shortcomings in the bank's practice of only updating its economic outlook quarterly. Its forecasts have been routinely running behind the economic curve. To hold rates steady now and say, "We're looking at the economic indicators, we'll let you know in our next quarterly update," when it's blindingly evident that the economy has trounced the bank's expectations, would have been farcical.
Indeed, Wednesday's rate decision may have come at the strongest moment we are going to see in support of a rate hike. By the time the October announcement rolls around, the economic case for further hikes may already be weakening.
Everyone – including the Bank of Canada – believes the economy will cool in the second half of the year. The export boom from earlier in the year has slowed significantly, perhaps related to a rising Canadian dollar; exports face further headwinds as the currency continues to climb. Inflation remains well below the bank's official 2-per-cent target, which is problematic for a central bank whose rate policy is expressly wedded to inflation targeting.
Crucially, the Bank of Canada will want to see how these two rate hikes play out with Canadian consumers, whose willingness to spend has been a critical component of the economic resurgence. (More than half of the second quarter's GDP growth came from household consumption.) Record-high household debt levels, coupled with extremely low interest rates at which most of that money has been borrowed, suggest that even small rate increases pose an oversized drag on consumer activity.
Still, by raising rates in the absence of more detailed communications, the markets are left trying to fill in their own blanks about the central bank's thinking. To make matters worse, this rate hike comes after a long stretch since the last time any Bank of Canada official has given a public speech – which is pretty typical for the bank over the summer vacation period, yet exacerbates the lack of new information accompanying this rate decision.
The Bank of Canada now has a pressing need to focus the next several weeks on clarifying its message – starting with a Sept. 18 speech from deputy governor Timothy Lane, followed by a speech by Governor Stephen Poloz the following week. Expect the bank to use those opportunities to remind markets that further rate increases remain dependent on the economic data – and those data don't come anywhere near suggesting we have a steady diet of rate hikes coming.