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3 indicators of future interest rate decisions

  • Mar 04, 2020

The Bank of Canada (BOC) cut its overnight rate by 50 basis points in response to potential economic damages stemming from the spread of the novel coronavirus. Lower interest rates are usually effective to stimulate demand and support consumer confidence. But they are not as useful when dealing with economic issues arising from plant closures, transportation restrictions, and other supply chain disruptions. 

Future adjustments to the BOC interest rate will be a function of the global virus outbreak and its influence on the Canadian economy. Here are three indicators to assess economic conditions: 

1. Inflation comes in all shapes and sizes

Overall inflation ran at 2.4% year-over-year (YoY) at the end of January, slightly accelerating. Higher inflation normally lessens the likelihood of an interest rate cut. There are two arguments for focusing on low and stable inflation - inflation erodes purchasing power and high inflation usually brings elevated uncertainty, which makes businesses reluctant to invest. 

Accelerating inflation isn’t a cause for concern. The BOC will assess inflationary pressures using measures like core inflation (eliminating the most volatile components of the total inflation) and CPI-trim (removing the parts of core inflation that show the largest rate of change). At this time, none suggest an imminent departure from the inflation target range.  

2. GDP measured against potential

A critical input to forecasting inflation is the gap between real economic activity (measured by GDP) and potential, a measure known as the output gap. When GDP is projected to be below potential, lower interest rates are expected. 

BOC estimated the output gap between 0.25% and 1.25% below potential in the last three months of 2019, an increase in excess capacity over the third quarter of 2019. This evaluation was made before the actual GDP data for the fourth quarter was released, and prior to the novel coronavirus reaching near-pandemic status. GDP grew at an annual pace of 0.3% in the fourth quarter of 2019, its weakest pace in four years. The output gap is projected to widen, but by how much? The BOC will revise its output gap estimate in April. 

3. Labour market remains robust

The national unemployment rate at the end of January was 5.5% and recorded modest growth in some areas of the country. Average hourly wages increased 4.2% YoY, consistent with a tight labour market. The next labour survey will be released on March 6. Labour market deterioration would increase the possibility of future rate cuts. 

Economic data drive future rate decisions

While the rate cut will stimulate the Canadian economy, we can’t rule out the possibility of seeing further cuts as the BOC analyzes new information and trends in inflation, the labour market and GDP. The global economic response to the virus will influence the length and magnitude of the 2020 economic cycle. Weaker economic growth could soften global food demand and lower agricultural commodity prices. But demand has proven to be resilient so far.  

J.P. Gervais
Vice-President and Chief Agricultural Economist

J.P. is the Vice-President and Chief Agricultural Economist at Farm Credit Canada. Prior to joining FCC in 2010, J.P. was a professor of agricultural economics at North Carolina State University and Laval University. He also held the Canada Research Chair in Agri-Industries and International Trade at Laval. J.P. is Past-President of the Canadian Agricultural Economics Society. He obtained his PhD in economics from Iowa State University in 1999.

@jpgervais