Bank of Canada Raises Benchmark Rate, Warns on Nafta Risk -- 2nd Update

By Paul VieiraFeaturesDow Jones Newswires

The Bank of Canada on Wednesday raised its main interest rate by a quarter percentage point to 1.25% on the strength of stellar employment data and a pickup in inflation. However, it signaled a cautious approach to further rate increases, warning that uncertainty tied to the future of the North American Free Trade Agreement is likely to exert a drag on growth.

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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Underlying economic fundamentals at home and abroad have strengthened, and would otherwise suggest a strong pickup in business investment and exports, the bank said. But trade-policy uncertainty would slow growth in both categories, it said.

"Recent data have been strong, inflation is close to target and the economy is operating roughly at capacity," the Bank of Canada said. "However, the uncertainty surrounding the future of Nafta is clouding the economic outlook."

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, BOC Gov. Stephen Poloz is indicating further rate rises won't be "fast and furious."

The central bank estimates the economy grew 3% last year, and is expected to expand 2.2% in 2018. It raised rates in July and September of last year, both by quarter percentage points. With Wednesday's rate rise, the Bank of Canada became the first central bank in the Group of Seven to raise rates in 2018.

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.

The Trump administration also has increasingly targeted products in the Canadian lumber, aerospace and paper sectors for additional tariffs, arguing they are benefiting from unfair trade practices. This has led to an escalation of political rhetoric between the trading partners, and prompted Canada to file an unusually broad trade complaint with the World Trade Organization against the U.S. trade regime.

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.

"While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target," the bank's statement said.

Overall, the Bank of Canada said slack, or unused capacity, in the labor market has disappeared more quickly than anticipated. 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 unfold 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 10:45 ET (15:45 GMT)