Monthly Economic Letter

July 2021

Feature article

How close is the Bank of Canada to raising interest rates?

In the spring of 2020, the Bank of Canada joined other central banks in cutting its key interest rate, bringing it down to a low of 0.25%. The bank also proceeded with massive asset purchases to inject money into the economy to support credit markets and sustain growth during the pandemic.

To date, the Canadian central bank's monetary policy has remained very accommodative. Of course, this stimulus will eventually have to be withdrawn. The question is not whether Canadian monetary policy will tighten, but when.

What could push interest rates up?

When the economy is operating at full capacity, there is a risk that inflation will rise above the level the Bank of Canada considers healthy for the economy—its so-called target range. Monetary stimulus (in the form of low rates) is then no longer needed to stimulate growth.

Recently, inflation has become a concern for many households and businesses. Inflation as measured by the consumer price index (CPI) rose above the bank's target range in April and May. The bank aims to keep the CPI at 2%, the midpoint of a 1% to 3% range. The CPI rose to 3.4% in April and 3.6% in May. Excluding volatile gasoline prices, it would have been about 1.9% and 2.5%, respectively.

Inflationary pressures are being felt in the country amid high demand and supply chain bottlenecks as health restrictions are eased and the economy reopens.

Much of the higher inflation is caused by temporary effects. These include the base effect and a lag in adjustment of supply and demand to the reopening of the economy.

The Bank of Canada's latest consumer outlook survey indicates medium-term inflation expectations remain anchored. So, inflation alone does not seem to be a sufficient reason for the bank to raise its policy rate over the next 12 months.

On the other hand, the Canadian economy has proven resilient in the face of the second and third waves of COVID-19. Bank Governor Tiff Macklem has said rate tightening could begin as early as mid-2022, earlier than previously planned.

The strength of the economy will likely improve further this summer, thanks to successful vaccination campaigns and the reopening of provincial economies. For this reason, we expect Canadian monetary policy to be reviewed in the coming months without any immediate movement in the policy rate.

Towards the end of quantitative easing

In the spring of 2020, the Bank of Canada decided to stimulate the economy furthermore, through asset purchases. By increasing the amount of money circulating in the economy, it helped lower long-term interest rates, which reduced the cost of borrowing for households and businesses and thus stimulated growth.

The bank announced its first reduction in its asset purchase program at the end of April—from $4 billion to $3 billion per week, a sign the economic outlook is improving in Canada. The bank is expected to discontinue the program by the end of the year, removing downward pressure on rates from the central bank. So, even without a rate hike, the Bank of Canada will be tightening credit conditions this year.

How high can rates go?

Effective interest rates in Canada were still very low at the end of June at 2.6% for households and 2.3% for businesses. Although rates are expected to rise, increases will not be immediate and will be gradual when they start.

Like other central banks, the Bank of Canada is trying to guide the economy to a sustainable pace of growth where neither stimulus nor restraint is needed.

A sustainable or neutral level would mean a policy rate between 1.75% and 2.75% in Canada. Today, the Bank of Canada's policy rate is 0.25%. This means  the policy rate would have to increase by 1.5 percentage points to reach the minimum neutral rate estimated by the bank.

Over the past few years, the bank has raised rates in increments of 25 basis points (0.25%). Of course, this is not a rule that the bank has to follow, but unless the economy spirals out of control, which is unlikely, it would be surprising if rates were to rise more quickly.

Businesses can expect gradual increases in effective interest rates, but these should not exceed the conditions that prevailed before the pandemic, around 3.5%. It will take several months, if not years, to reach that level.

Thus, we will continue to be in a low interest environment for several more months, but the trend is upward. Companies should consider taking advantage of current rates to finance their projects before they begin to rise.

Canadian economy at a glance

Reopening of the economy could produce a positive second quarter

Despite the resurgence of the pandemic across the country and an increase in restrictive measures during the second quarter, the Canadian economy proved to be more resilient than expected.

This strength, coupled with the reopening of provincial economies in June, suggests that positive growth was achieved in the second quarter, although a Bank of Canada 3.5% estimate in April seems a bit high in the circumstances.

First decline in Canadian GDP in April

In April, Canada's gross domestic product fell for the first time in a year. The last monthly decline in GDP was in April 2020 when the global economy was put on pause. GDP fell by 0.3% between March and April 2021.

However, the consensus view of economists, as well as Statistics Canada's preliminary estimates, had pointed to a much more severe decline. What’s more, economic activity for March was revised upward (1.3% rather than 1.1%). This means that April's decline started from a higher level.

With most provincial health measures continuing in May, Statistics Canada estimates that GDP declined by 0.3% in that month as well. This would put economic activity at 98.5% of its pre-pandemic level.

Retail activity tracks pandemic progress

The retail industry has seen its ups and downs during the pandemic. While many businesses have adjusted to the situation by increasing their online offerings, the sector’s fortunes continue to track the health situation.

In the face of spring restrictions, including the closure of non-essential businesses in several provinces, retail sales fell 5.7% in April and likely by 3.5% in May, according to early estimates.

The outlook for June improved as stores reopened. As a result, a significant rebound in consumer spending is expected, reflecting pent-up demand from the third wave. The consumer confidence index has resumed its upward trend.

The housing sector is at the heart of the recovery

Together, the construction and real estate services sectors account for about 20% of the Canadian economy.

Housing starts rebounded in May after a decline in April. While still above their trend level of the past few years, they are still far from their March peak.

Construction GDP increased by 2.4% between April and March, despite the decline in housing starts. The sector is expected to continue its positive contribution to economic activity in the coming months.

The resale market moderated for another month in May. The supply side of the market continues to weaken and there is evidence of demand-side fatigue. Faced with new challenges in the current market, such as multiple offers, overbidding and reduced sales conditions, some households may indeed have begun to lose interest. The real estate services sector declined by 0.7%. This is the first notable monthly decline for the sector since the first lockdown in April 2020.

Prices will remain high as long as supply remains low.

Employment is on the rise

The Canadian economy added 231,000 jobs in June. The economy therefore recovered most of the losses accounted during the third wave (275 thousand in April and May). The sectors most affected by the lockdowns, and therefore first to benefit from virus containment measures easing in June, contributed the most to the rebound in employment. This was the case for retail trade (+75,000) but especially for the food services and accommodation industries (+101,000).

The impact on your business

  • The months of April and May will likely have put the economic recovery on ice for many businesses this spring. It is likely that households will have continued to save during these months, making them even more likely to spend this summer.
  • The health situation is finally improving across the country. Much uncertainty still remained, but vaccination campaign continue at a good pace which will allow for more flexibility, and therefore reopening, in July and August.
  • The search for staff will intensify with the reopening of the economy this summer. Immigration alone will likely not be enough to meet your long-term labor needs, think about how you can automate your processes today.

U.S. economy at a glance

Challenges mount, but growth persists

The U.S. economy grew by 6.4% in the first quarter and robust growth was expected to continue in the second.

Despite supply-chain bottlenecks and labour shortages, the U.S. remains on track to post its strongest annual economic growth in 35 years.

Consumption downturn

The global economic recovery has relied heavily on the consumption of goods over the past year. In the U.S., consumer spending on goods surpassed pre-pandemic levels while spending on services sagged. The tables finally turned in May.

Households seem to be quietly starting to allocate their budgets more "normally." Americans have increased their spending on services as the economy reopens (+0.4% between May and April) at the expense of goods consumption, which is slowing (-4.3% for durable goods).

Much of the slowdown in consumer spending can probably be explained by the fading of fiscal stimulus received in March. Another hypothesis is that goods consumption is being crimped by limited capacity in the manufacturing sector.

Factories running at full speed

The manufacturing sector has benefitted from the goods boom and continues to perform well. The manufacturing purchasing managers' index remained strong in June despite a slight decline from May (-0.6 percentage points).

The sector continues to expand but is struggling to meet demand. Reduced production capacity and supply-chain challenges are creating upward pressure on production prices.

850,000 new jobs in June

Before the pandemic hit, the U.S. labour market was on an unprecedented tear. The unemployment rate was at an all-time low of 3.5%, and the economy was adding hundreds of thousands of jobs each month, despite an already high level of employment.

Gains since the start of the recovery are still far from pre-crisis levels. However, the addition of 850,000 jobs in June is obviously welcome after somewhat disappointing results in the spring. (The U.S. economy added a total of 852,000 jobs in April and May as the economy began to reopen.)

Is this a return to the pre-pandemic trend of tight job markets in the U.S.? The country is facing a major labour shortage problem. The ratio of open jobs to available workers is peaking. And the pool of potential workers is still well below where it was before the crisis. Retirements continue to rise and immigration is down due to the COVID-19 crisis.

Most of the jobs recovered recently are in sectors hit hard by the pandemic, while businesses in other sectors are struggling to find workers. Labour issues could undermine the U.S. economic boom in the coming months.

Fed's dual mandate put to the test

The Federal Reserve finally moved up its inflation forecast but remains convinced that strongly rising consumer prices are a transitory phenomenon. Chairman Jerome Powell recently argued before Congress that the situation still doesn’t justify a reduction in stimulative asset purchases.

However, there are signs the Fed may reverse this decision in the early fall. For one thing, Powell’s statement was made before the release of June jobs data, which were quite encouraging. Also, core inflation jumped 3.8% in May, a 29-year high. Most of the increase was due to the base effect of certain price categories directly affected by health restrictions, but upward price pressure is increasingly spreading to various other categories.

If employment continues its June momentum (which remains uncertain), then the central bank will have enough of a case to slow its asset purchase program. Remember that the Fed has a dual mandate to ensure price stability and full and inclusive employment.

The impact on your business

  • The United States is headed for a year of exceptional economic growth. As a major trading partner, the Canadian economy will benefit from this growth.
  • Many sectors, particularly manufacturing, are finding it increasingly difficult to meet demand due to supply or labour issues. If your business model or investment plans rely in part on importing U.S. goods and technology be sure to diversify your suppliers to avoid delays.
  • Labour issues are beginning to weigh on both sides of the Canada-U.S. border. They may make competition for talent more intense. Find out how your company can attract and retain the workers it needs.

Oil market update

Oil prices surge just in time for the summer driving season

It’s quite common to see prices at the pump increase just before the summer driving season, but there’s more behind a recent jump in gasoline prices than just a reaction to seasonal demand.

West Texas Intermediate and Brent, the main crude oil benchmarks, were trading at over US$75 per barrel in early July after rising by 13% and 10%, respectively, in June.

The price spike is due to both increased demand and supply constraints. But the main driver of higher prices in early July was uncertainty and discord within the Organization of the Petroleum Exporting Countries and its allies (OPEC+).

Surge in demand

For several weeks now, markets have been expecting a surge in demand for crude as economies reopen from pandemic health restrictions. However, the strength of the demand increase has proven greater than anticipated. The impact of vaccination campaigns in limiting the spread of COVID finally seems to be outweighing fears about variants.

Several countries are slowly reopening their borders to international travellers. Observers expect air travel to remain below its pre-pandemic level this year but still contribute to a significant turnaround in oil demand.

Tensions rise within OPEC+

In May 2020, OPEC+ agreed to cut production by 9.7 million barrels per day (mb/d) in response to a collapse in global demand following the pandemic. While restrictions have been partly lifted, they still amount to about 5.8 mb/d.

During three days of meetings at the beginning of July, OPEC+ considered increasing production by about 2 mb/d in stages between August and December. From there, Saudi Arabia wants to extend the remaining OPEC+ output limits until the end of 2022, instead of allowing them to expire in April as planned.

However, the proposal ran into stiff opposition from the United Arab Emirates (UAE), which is anxious to pump more oil, and the meetings ended with no deal.

Production curbs are based on the capacity of each country in 2018. The UAE’s maximum capacity at that time was 3.2 mb/d.

However, since 2018, expansion projects have brought the UAE's capacity to about 4 mb/d. This growth would allow it to extract hundreds of thousands of additional barrels per day while still respecting the OPEC+ agreement, but Saudi Arabia is resisting.

If OPEC+ members do not come to an agreement before the end of the month, countries will have to maintain production at their current reduced levels. This could leave supply too low to meet demand in the fall, leading to significant price increases.

It’s estimated that an additional 400,000 barrels per day added each month starting in August would be needed to keep the market in balance. Some analysts have warned a barrel could hit US$100 by the end of the year if no agreement is reached.

Impact at the pump

With inflation fears already making headlines, rising oil prices would create significant upward pressure on prices at the pump. According to the consulting firm Kalibrate, a $1 crude oil price increase translates to a half-cent increase at the pump in Canada.

Higher gasoline prices could not only slow the economic recovery as consumers are forced to limit their travel but also exacerbate price increases on other goods such as food and commodities due to increased transportation costs.

Other economic indicators

The Bank of Canada seems to have got it right

The economy appeared to be tracking fairly closely the Bank of Canada’s forecasts in the second quarter. The resilience of the economy and the optimistic results of the latest business outlook survey provide support for the bank to further reduce its asset purchase program.

The loonie is going down

As the U.S. Federal Reserve adopted a more hawkish stance in June, markets reacted to the new inflation outlook. Investors are more fearful of riskier assets such as commodity linked currencies, including the Canadian dollar. As a result, the loonie depreciated against the U.S. dollar in June, closing the month just shy of US$0.80.

SME optimism reaches a record high

The reopening of the Canadian economy has boosted business sentiment. The latest BDC survey shows that more than half of business owners expect the economy to improve in the coming year—the highest level on record. The good news is that this optimism is also boosting business investment intentions to meet rising demand, which should further contribute to growth.

Upward pressure on prices continues

The reopening of the economy and strong pent-up demand are leading businesses to raise prices. According to the Bank of Canada, the share of firms considering raising their selling prices still exceeds the share of firms considering lowering them. Despite the decline since last quarter, inflationary pressures are expected to continue. These companies probably think they will be able to pass on some of the cost increases to their customers or want to make up for the losses of the past few months.

Key indicators—Canada

BDC MEL july 2021 key indicators Enlarge the table