Bank of Canada Raises Benchmark Rate, Warns on Nafta Risk -- 3rd Update

By FeaturesDow Jones Newswires

The Bank of Canada said Wednesday a strong economy prompted another increase in its main interest rate, the third in seven months, but said it would move gradually on further increases given the uncertain fate of the North American Free Trade Agreement.

The rate increase was widely anticipated, according to a survey of economists by The Wall Street Journal, after Canada's unemployment rate fell to a historically low level of 5.7% and annual inflation rose above the central bank's 2% target in November. The statement explaining the Bank of Canada's rationale and its economic outlook, however, contained its most explicit assessment to date about the negative fallout from Nafta's uncertain future.

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The central bank said its economic outlook is expected to "warrant higher interest rates over time," as labor-market conditions continue to shine and inflation is close to its 2% target. Yet, it signaled current rate levels could be required for some time to address a number of factors -- among them the drag on business investment and export growth from uncertainty surrounding Nafta.

Bank of Canada Gov. Stephen Poloz said Wednesday's quarter-percentage-point increase, to 1.25%, "validates what we see" in the economy. Nafta, however, "is a very big unknown for us," Mr. Poloz told reporters at a press conference, including how its dissolution could affect the economy. He later said his biggest concern focused on the impact the end of Nafta could have on business investment in Canada, which Mr. Poloz warned could be significant as firms contemplate a post-Nafta strategy.

"We can't just relax and assume it will be a small shock" should Nafta talks fail, Mr. Poloz said. He added the Trump administration also could unveil fresh measures that affect Canadian trade, citing recent tariffs the Commerce Department imposed on softwood lumber and commercial jets.

Canada sends roughly three-quarters of its exports to the U.S., or the equivalent of 20% of total economic output. Trade flows are potentially at risk as the U.S., Canada and Mexico renegotiate Nafta at the behest of the Trump administration. Talks have taken a contentious turn, and will resume next week in Montreal. President Donald Trump told The Wall Street Journal last week he is prepared to withdraw from the deal unless significant changes demanded by the U.S. are made.

In its decision Wednesday, the Bank of Canada said underlying economic fundamentals at home and abroad have strengthened, and would otherwise suggest a strong pickup in business investment and exports. But trade-policy uncertainty would slow growth in both categories, it said.

The rate increase "was a rear view mirror move, but the Bank of Canada hints that the view out the front window isn't quite as sunny," said Avery Shenfeld, chief economist at CIBC World Markets. He added that, by giving Nafta uncertainty prominent play in the rate statement, Mr. Poloz is indicating further rate rises won't be "fast and furious."

Not all Bank of Canada watchers shared that view. Derek Holt, economist at Bank of Nova Scotia, said there was "nothing in the broad set of communications that stands in the way of further [rate] hikes." Mr. Holt said even with a more pronounced focus on the Nafta risk, the central bank's growth forecast barely changed from the previous quarter, with expectations of growth at 3% for last year and 2.2% for 2018.

In his press conference, Mr. Poloz said the central bank remained "fully data dependent" when it came to crafting policy decisions.

Developments on the Nafta and U.S. policy front prompted the Canadian central bank to incorporate a "negative judgment" on capital spending and trade. The level of business investment is expected to be 2% lower by 2020 than what would otherwise be the case due to trade-policy uncertainty, the Bank of Canada estimated. It also warned recent U.S. tax cuts -- bringing the corporate rate down to 21% from 35% -- could "reinforce these uncertainty effects," with companies opting to shift planned capital expenditures from Canada to the U.S.

As for trade, the central bank said the Nafta risk would hinder Canadian exporters' ability to benefit from an improving global outlook. Trade-policy uncertainty is expected to hold back exports by 0.7% by 2020, the bank said.

Wage-growth pressures, it said, have picked up but "remain modest." Further, the central bank said it is monitoring the extent to which stronger demand and investment are boosting the level of potential gross domestic product, or the amount of growth that can occur before inflationary pressures are triggered. The central bank sets rate policy with the aim of reaching and maintaining 2% inflation.

The central bank said it expects inflation to remain close to its 2% target through 2019.

Write to Paul Vieira at paul.vieira@wsj.com

(END) Dow Jones Newswires

January 17, 2018 15:21 ET (20:21 GMT)

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