Bank of Canada raises key interest rate target to 1.5%

The decision, a move that prompted some of the big banks to start raising their prime rates later in the day, arrived in the middle of a trade dispute between Canada and the United States that’s expected to hurt both economies.

Poloz made the call even though he warned the economy should brace for larger impacts from mounting trade uncertainty. In particular, the trade impacts were caused by the Trump administration’s recent steel and aluminum tariffs on Canada and, in response, Ottawa’s retaliatory duties on U.S. imports.

The tariff fight is expected to shave two-thirds of a percentage from Canada’s economic growth by the end of 2020, the bank estimated.

Poloz said despite the combined effects of the metals levies, and earlier U.S. tariffs on products like softwood lumber, the bank still projects Canadian growth to average a promising level of 2% over the next few years, just slightly above its potential and with inflation already on target.

The bank expects the negative blow of the trade policies to be largely offset by higher oil prices and the stronger U.S. economy — both of which, on balance, will benefit Canada.

Looking ahead, the Bank of Canada is also predicting exports and business investment, which were both stronger than expected in the first three months of the year, to churn out bigger contributions to growth. At the same time, it expects household spending to make up a smaller and smaller share of overall growth due to the dampening effects of higher interest rates and stricter mortgage rules.

With the positive outlook, Poloz expects interest rates to continue along their cautious, upward path.

“It’s evident to us that higher interest rates will be warranted, but of course we’re not in a position to say exactly how much higher or at what rate we might get there,” Poloz told a news conference Wednesday in Ottawa.

Poloz stressed the bank will continue with its gradual, data-dependent approach as it moves towards its neutral rate, which his team has pegged between 2.5% and 3.5%.

Along the way, the bank will have to keep close watch on another trade-related unknown that many believe would inflict far more damage on the economy: U.S. duties on the automotive sector.

U.S. President Donald Trump has threatened to slap tariffs on the auto sector, which is made up of highly integrated, cross-border supply chains. The Bank of Canada warned that auto levies would have “large impacts on investment and employment.”

The bank, however, didn’t quantify the possible effects of auto tariffs on Wednesday.

For one, Poloz said the bank can’t make policy decisions based on “hypothetical scenarios.” He added that the unknowns around trade could also include positive developments such as the successful renegotiation of the North American Free Trade Agreement over the coming months.

“We need to base our decision on what we actually know,” he said.

Poloz also argued it should be clear that interest rate adjustments are “ill-suited” to counteract all the effects of protectionist measures, given how these trade actions affect multiple areas of the economy.

In addition to tariffs, Canadian businesses must also contend with the uncertainty surrounding the stalled talks on NAFTA’s renegotiation.

Outside the country, the Bank of Canada has its eye on how widening global trade disputes, including an intensifying battle between the U.S. and China, will affect the world’s economy. It warns that “escalating trade tensions pose considerable risks to the outlook” at the global level.

Even with the trade issues, the Bank of Canada is predicting slightly stronger growth for Canada over the next couple of years, according to updated projections released Wednesday in its quarterly monetary policy report.

It expects real gross domestic product to grow 2.2% in 2019, up from its April call of 2.1%, and by 1.9% in 2020, compared with its previous prediction of 1.8%. The economy’s growth projection for this year remains at 2%, the bank said.

Many economists anticipate several more hikes this year and in 2019.

TD senior economist Brian DePratto wrote in a note to clients Wednesday that the messaging is consistent with a central bank that’s “committed to a rate hike cycle, but leaves sufficient room to adjust to evolving events.”

National Bank of Canada experts wrote in a note that Poloz may choose to err on the side of caution when it comes to future hikes because of threats of auto tariffs, which they warned, if applied, would have “unambiguously devastating economic impacts,” particularly in Ontario.

Leading up to the announcement, Poloz was widely expected to raise the interest rate following a run of encouraging economic numbers, including the Bank of Canada’s own survey on business sentiment, still-solid job markets and growth in wages.

The bank, however, noted in its report that despite “healthy” labour market conditions, employment growth and average hours worked have slowed down compared to last year’s surge. It also said underlying wage growth has been weaker than what would normally be expected in a tightened job market.

The country’s inflation rate is expected to rise as high as 2.5% — above the 2% mid-point of the bank’s target range — due to temporary factors such as higher gasoline prices. It’s expected to settle back down to 2% in the second half of 2019.