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The Globe and Mail

The Bank of Canada’s tone shift should be a cause for concern

Steve Ambler is David Dodge Chair in Monetary Policy at the C.D. Howe Institute; Jeremy Kronick is a senior policy analyst at the C.D. Howe Institute

The Bank of Canada announced on Wednesday, in a familiar refrain, that it is maintaining its target for the overnight rate. However, the announcement and accompanying news conference signalled a definite change of tone. Barring major negative surprises, it took the possibility of a rate cut off the table. With inflation at target, should the positive economic news continue, a rate hike before 2018 is a real possibility. Two questions arise: first, what might cause this earlier rate hike, and second, is it necessarily a good thing?

Positive economic news that leads to an improvement in the real economy, and thereby an increase in inflation would be a good problem for the Bank of Canada. However, there are at least two other scenarios in play that could force consideration of a rate hike but which are trickier to deal with.

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The first scenario has to do with rate hikes by the Federal Reserve Bank in the United States. The Fed increased its federal funds rate by 25 basis points on March 15, and most analysts predict two more 25-basis-point increases before the end of 2017. The Bank of Canada, in its most recent Monetary Policy Report, briefly noted the March increase but was silent concerning the possible impact of further Fed rate increases this year.

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The predictions of two further rate increases by the Fed are not completely baked into the markets because of the uncertainty surrounding these predictions. Should they come to fruition, the Canadian dollar will weaken if the Bank holds its rate steady. While a weaker Canadian dollar would be a good thing for exports and the economy, it also makes importing goods more expensive, directly leading to higher inflation. Businesses that rely on imports for domestic production will also face higher costs.

The Bank should, of course, not base its policy decisions on what the Fed is doing, nor should it react directly to exchange rate fluctuations. A flexible exchange-rate regime conveys a high degree of monetary policy independence to the Bank. Nevertheless, the Bank will have to take the consequences of the Fed's actions for the domestic economy into account, and import versus export-based inflation tell very different economic stories.

The second scenario, an output gap closing sooner than expected, is more problematic. The output gap is the difference between actual GDP and potential GDP (the latter measures what GDP would be when resources are fully employed).

Often, the closing of an output gap is a good thing, especially if actual or potential GDP is increasing. Indeed, higher-than-expected GDP growth in the last quarter of 2016 and the first quarter of 2017 has been responsible for some of the closing of the output gap.

However, the Bank recently revised its estimate of potential output downward due to weakness in capital accumulation and productivity growth. A narrowing output gap due to falling potential is not a good thing, but the types of policies that favour investment and productivity growth are beyond its control.

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Of additional concern is that no matter how the gap narrows – including through falling potential – we still end up with upward pressure on wages and production costs. This would in turn feed through to inflation, which is already at target and predicted by the Bank to remain there for the rest of the year. If inflation is pushed above target, the Bank may be forced to consider a rate hike.

Of course, the Bank of Canada has flexibility to consider the cause of rising inflation. During the news conference, Governor Stephen Poloz said as much, stressing that an economy running at full capacity and inflation equal to its target does not guarantee a rate hike.

Downside risks, such as financial-stability concerns or trade protectionism, would speak for keeping the overnight rate where it is.

However, as inflation increases, pressures for a hike will mount. The Bank must hope that a strong real economy is the cause of above-target inflation – and not lower potential.

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