Bank of Canada downgrades view of economy

The Bank of Canada’s statement following its meeting showed a less optimistic view towards the global and Canadian economies and less urgency to tighten rates.. I expect CAD to weaken further going forward as a result.

Although the BoC admitted that inflation has hit their 2% target earlier than expected, they said it was due to “temporary factors,” such as higher energy prices and the weakening of the CAD, not due  to any change in economic fundamentals. They predicted inflation would “fluctuate around 2%” for the next two years, which implies that they have no need to tighten policy during that time.*

Their assessment of the economy was definitely more negative than it was in June. “The global economy is on a lower growth track than was foreseen at the time of the April Monetary Policy Report,” they said. Given that downgrade “…economic activity in Canada is now projected to be a little weaker than previously forecast.” Significantly, they added that “the Bank still expects that the lower Canadian dollar and a projected strengthening in global demand will lead to a pickup in Canadian exports and business investment and, eventually, a more sustainable growth track.” In other words, the recovery still depends on a weak CAD. They returned to this idea later in the statement when they said that closing the output gap “hinges critically on stronger exports and business investment.” Thus again, stronger exports – and hence a weak or weaker CAD – are necessary for them to achieve their goal.  

They also said that “the economy is expected to reach full capacity around mid-2016, a little later than anticipated in April,” meaning the anticipated date for any tightening to start is pushed out somewhat (“early 2016” was the previous forecast). That alone would seem to be worth more than 30 pips on the price of USD/CAD, in my view.  

Given that they believe global growth has slowed and yet they still expect the recovery to depend on a pickup in exports, it’s essential that they keep CAD from appreciating. I would expect them to maintain their neutral bias, particularly as they do not see higher inflation as a significant risk, and that any major strengthening in the exchange rate will be met by verbal intervention, such as comments again about “ongoing competitiveness challenges, including the persistent strength of the Canadian dollar,” as they used to say back when USD/CAD was sub-1.0. I would expect them to also push out the time when they expect the economy to reach full capacity, which is in effect forward guidance about when they may start hiking rates.

All told I view the statement as dovish and generally bullish for USD/CAD (= bearish for CAD).

*BoC’s inflation target is to keep total CPI inflation in the middle of a 1 to 3 percent target range over the medium term. So 2 percent is the middle of their target range; they don't have to get too concerned if it goes over 2 percent, because their "line in the sand" for inflation is 3 percent.