By Michael O’Neill

“Interest rates are very low considering that the economy is pretty well at capacity, inflation is at two percent. So there is a sense, almost by law of gravity, interest rates will move somewhat higher over time.”

Bank of Canada (BoC) Governor Stephen Poloz said those words during his April 18 press conference, confirming what most economists and analysts suspected.

The BoC left interest rates unchanged at 1½ % and then delivered a relatively optimistic outlook along with the usual caveats for caution.

The monetary policy statement noted that Canadian inflation is at or close to the 2% target.  It appears to have some upside as “factors weighing on inflation have largely dissipated.” They noted that core CPI is close to 2% as well which indicates that “there is little slack in the economy.”

The BoC acknowledge that Q1 GDP growth was weaker than they had forecast but said they expected it to rebound in Q2, resulting in a 2% growth rate for the first half of 2018.  They blamed the weak growth to changes in the mortgage guidelines and transportation bottlenecks acting as a drag on exports.

Source: Bank of Canada Monetary Policy Report

The quarterly Monetary Policy Report accompanied the policy statement.  The MPR balances some of the optimism in the statement by noting some concerns that would affect their outlook.  They are a tad uncertain as to whether the domestic economy can remain at full capacity, especially if Q2 growth doesn’t unfold as expected.

The Bank said that even if interest rates go higher to keep inflation on target, they may have to stay below the “neutral range” until various forces have dissipated, citing trade uncertainties and geopolitical risks.”  That is Bank-speak for rates may go higher but at this point not above 2.5% 

The Canadian dollar responded negatively to the policy statement and MPR.  USDCAD touched 1.2530 yesterday and 1.2658 during Mr Poloz’s press conference.  That move is mostly a factor of short-term positioning than a judgement of today’s BoC outlook.

Mr Poloz has repeatedly said that the Bank of Canada must be cautious in its monetary policy approach due to the large degree of uncertainty surrounding any forecast.  The BoC cited global trade and geopolitical issues as reasons to be cautious.

He has right to be leery.

President Trump continually contradicts himself on global trade.  Nafta has gone from “worst deal ever,” to urgently needing an outline of agreement, to “a deal when it happens.”   Trump removed the US from the TransPacific Partnership within days of taking office.  Last week, he reportedly told Ben Sasse, Senator from Nebraska, that he wants to have US Trade Representative Robert Lighthizer look at re-entering the TPP.  That was the flip.  On Tuesday, April 17, the President tweeted “While Japan and South Korea would like us to go back into TPP, I don’t like the deal for the United States. Too many contingencies and no way to get out if it doesn’t work. Bilateral deals are far more efficient, profitable and better for OUR workers. Look how bad WTO is to U.S.”  That was the flop.

Weekly policy turnabouts by the world’s biggest economy give G10 central bank forecasters, nightmares.  How do you formulate monetary policy if economic and geopolitical policy changes at the speed of a “Tweet?”

Geopolitical risks are another consideration that necessitates a cautious stance by Mr Poloz and company.  Financial and FX markets seem to have become desensitized to bomb blasts, missile attacks, cyber-attacks, the return to the cold war and China’s global ambitions.

A terror attack in a major city still garners headlines and tweets of “thoughts and prayers” but hardly a ripple in financial circles.  Shifts to risk aversion trades last hours instead of days.

It’s not only China’s trade spat with the American’s that is concerning, but China’s creeping annexation and militarization of the South China Sea.   China has decided that the South China Sea is theirs, ignoring claims from Brunei, Malaysia, the Philippines Vietnam, and Taiwan.  They have built military bases on seven islands to help defend their view.   China government ships have intruded into Japanese waters as well.

China does not recognize Taiwan.  To Beijing, Taiwan is a rogue territory., not an independent country.  Taiwan sees it differently and the US helps keep China’s aspirations in check.  That hasn’t stopped China from flexing their muscles by holding live-fire war games in the Taiwan Strait.  President Trump stirred the pot when he signed a bill encouraging high-level travel between the US and Taiwan.

The Middle East is another flashpoint.  Turkey, a Nato ally has an on-again-off-again relationship with Russia.  Turkey is attacking Kurdish forces who are fighting ISIS and who are US allies.  If that’s not enough, Turkey is picking a fight with Greece.

Saudi Arabia and Iran are conducting what some describe as a proxy war in Yemen.  Iran supports Yemen rebels while the Saudi’s are on the side of the government.  Israel is also at it with Iran.  They are rumoured to have attacked an Iranian drone base.  Iran wants to destroy Israel.

Russia has annexed the Crimea, shot down a passenger plane, meddled in the US election, and used a nerve agent to poison a former spy living in the UK. 

Anyone of these areas could explode and disrupt the global economy.  Canadian interests are going higher but the Bank of Canada’s caution is prudent.