Inflation surge to test BoC’s resolve on low rates

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The Bank of Canada is all but certain to stand still on monetary policy when it issues its new update this week – but it will have to deal with a lot of moving parts to get there.

The central bank releases both its regularly scheduled interest-rate policy statement and its quarterly Monetary Policy Report (MPR) Wednesday morning. While there's no risk that Governor Stephen Poloz will alter the bank's key policy rate, which has held at 1 per cent for nearly four years, the markets will be watching intently for changes in the central bank's economic and inflation outlooks.

The recent surprising surge in inflation – the single most important indicator guiding the Bank of Canada's interest rates – will test the bank's resolve in its low-rates-for-longer policy stance. At the same time, it will be balancing this against disappointing economic performance, a divergence in growth between Western and Eastern Canada, a stalled labour market and a rising Canadian dollar.

"It's not going to be an easy call for them," said Stéfane Marion, chief economist at National Bank Financial. "It's going to be hard to remain soft on inflation. [But] there are some challenges. We have a two-speed economy."

Given that the Bank of Canada uses a 2-per-cent inflation target as its guide for setting monetary policy, this creates problems: CPI has not only moved above the target, but it got there months ahead of the bank's forecasts. In its last MPR, in April, the central bank projected that CPI wouldn't reach 2 per cent until the first quarter of 2015.

The central bank has maintained that the spike in inflation is temporary, caused mainly by the weakening of the Canadian dollar over the past year and by a surge in energy prices. And its so-called core inflation rate – which excludes the most volatile components such as food and energy, and which is more closely watched by the bank because it better represents broad, underlying price pressures – is a relatively tame 1.7 per cent, still comfortably below the 2-per-cent inflation target. That said, core inflation has also surged more quickly than expected in recent months, and is at a level the central bank hadn't anticipated until the second quarter of 2015.

With economic growth still tepid (a thin 0.1 per cent in April, after just 1.2 per cent annualized in the first quarter), the employment market stumbling (the economy lost 9,400 jobs in June and the unemployment rate rose slightly to 7.1 per cent) and the bank's recent Business Outlook Survey indicating that companies aren't running short on production capacity, broader inflation pressures may not be in place yet. Nevertheless, observers believe the central bank will use the MPR to go into more detail on its current views on inflation – and will almost certainly revise its inflation forecast.

"The higher starting point to inflation means that the bank's economic projections will show core inflation returning to target before [its current forecast of] early 2016, possibly by the fourth quarter of 2014," said David Madani, Canada economist for Capital Economics, in a research note last week. "However, we don't expect material changes to its GDP growth [forecast] of 2.5 per cent in 2014 and 2015."

Mr. Poloz might also temper the central bank's language in the interest-rate statement about the risks of inflation falling to dangerously low levels, something that seemed possible at the start of the year. The bank's continued talk of downside inflation risks has been considered a signal that it might consider an interest-rate cut in its next policy move.

"I'm not sure if they will remove that line about downside risks, but they may have to soften it," said Nick Rowe, an economics professor at Carleton University in Ottawa.

Meanwhile, expect the central bank to continue to harp on two of its key themes for economic recovery: exports and business investment. Business investment has so far shown only glimmers of improvement. And while exports have started to look up thanks to growing signs of U.S. economic acceleration, the recent upturn in the Canadian dollar raises questions about how much more benefit Canadian exporters will see from a relatively cheap currency.

The dollar's run-up may be as good a reason as any to expect the central bank to maintain its lower-for-longer position on interest rates. There's a general sense that Mr. Poloz was happy to see the currency fall (and even helped it down) last year, and a relatively slow path to eventual rate increases would keep downward pressure on the currency.

"The more the Bank of Canada shows its hand, by twisting its language into a pretzel to sound more dovish than [U.S. Federal Reserve Chair] Janet Yellen, the more it is signalling that it doesn't intend to do anything that will help sustain a stronger loonie," Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, said in a research note.