The reaction in the loonie is just what the Bank of Canada needed with economic activity practically grinding to a halt in Q4.
While transitory events are likely to taint the GDP figure at the back end of last year, suppressed economic activity along with rising public infrastructure spending suggests capacity constraints may begin to alleviate as the output gap widens.
However, as per the winter Business Outlook Survey, the main concern for businesses increasing output is supply restraints in the labour market, which has remained tight by historical metrics for some time now. From an inflationary outlook though, looser capacity constraints outside of the labour market pose the most substantial deflationary risk to the bank’s current outlook, as highlighted in chart 2 below.
The Monetary Policy Report highlights this shift in risk parameters for the BoC’s outlook from external headwinds to more domestic factors in 2020.
Despite the financial market reaction, the projections don’t suggest a rate cut is a foregone conclusion before Poloz’s term ends.
The main takeaway from Wednesday’s Bank of Canada meeting is that the Governing Council may revert to verbal stimulus and therefore play a game of cat and mouse with financial markets while the data materialises as opposed to a more conservative insurance rate cut.
For now, a weaker currency is definitely favourable, especially considering the drag export growth had in the fourth quarter and the drag heightened imports are expected to have on Q1 this year (chart 1).
From an inflationary standpoint, measuring the development of the output gap and the reassessment of the neutral rate in April will be key for nailing in the next policy move as economic activity is closely monitored in the meantime.
Until then, without a substantial downturn in the data for Q1, it is hard to envisage a cut in before April being the likeliest option, especially with Governor Poloz ruling out an insurance rate cut. If the loonie continues to trade at a weaker level and fiscal stimulus provides mild support for growth, the bank is likely to embark on a holding pattern until the data suggests otherwise.
Governor Poloz showed that the central bank will return to sitting behind the curve and policy will be data dependent.
Chart 1: Both Governor Poloz and Deputy Wilkins stressed the importance of Chart 5 of the MPR when discussing the bank’s forecast for the growth rebound in Q1.
Chart 2: Deputy Wilkins stressed the impact that a widening output gap will have on inflation, adding extra emphasis towards the April projections
Chart 3: USDCAD hits a 2020 high as markets begin to price in the increased probability of a rate cut in March
In the coming months, metrics of economic activity, the development of house prices, the willingness of consumers to spend at the margin, and current account dynamics will be key for predicting the next policy move.
The data calendar is likely to return as a source of volatility for USDCAD for this reason.
Author: Simon Harvey, FX Market Analyst at Monex Europe.