Interest Rate Forecast

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1 Interest Rate Forecast Economics December Highlights Fed normalization begins More policy moves in China Canada s uneven economy BoC on hold, lower CAD Per cent U.S. Federal Funds Rate A continuation of constrained uneven global growth is likely during and, though a major economic downturn cannot be ruled out, there are no significant economic or financial imbalances or signs of overheating. Several economies will receive further monetary easing with some assistance from fiscal policy, which will generate more growth over time. Brighter prospects for are expected. The U.S. economy is on a different course than most and its monetary policy setting will affect currency markets. Canada stands to benefit from a more robust economic neighbor and its largest trading partner, though the low loonie also brings negative impacts and, until exports rise on a sustained basis, its slow-to-moderate growth phase will continue. Fed embarks on normalization The most anticipated rate hike in memory finally occurred when the Fed raised the fed funds target rate range 2 basis points to 0.2%-0.0% after more than six years at the zero-bound following the Great Financial Crisis and the first rate increase in nearly ten years. The FOMC statement emphasized gradual in the outlook for policy and was data dependent on economic conditions. This move was overdue and would have occurred earlier, likely in September, had not external developments intervened. The Fed s interest rate projections indicated the target rate could be 100 basis points higher by 0 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Source: U.S. Federal Reserve. Latest: Dec-1 the end of and the median estimate for the end of was 3.3%. Thus, the median projection implies four 2 bps hikes in and another four in and the Fed sees rates normalizing in These rate projections and their economic projections are little changed from three months ago. The U.S. prime lending rate increased to 3.0% from 3.2%. This small rate increase is unlikely to have a significant effect on housing, autos, or consumers. The Fed s future rate path will take into account current economic conditions and future economic prospects such that growth is not constrained until inflation becomes a problem. While some label this rate move as monetary tightening, it is better described as rate normalization off emergency levels. Monetary tightening occurs when a central bank raises rates to bring down inflation. With the Fed beginning to normalize interest rates, it does not want to reverse course as has occurred in several countries that raised rates since Canada, Australia, Japan, and the ECB are some examples where the central bank reversed course. While unforeseen events will happen during the Fed s normalization phase, and may cause a rate reversal, it will err on the side of caution and pro-growth in the initial stages. The federal funds futures market currently anticipates only two rate hikes next year rather than 1

2 four implied by the Fed s median projection. This forecaster expects two or three 2 bps increases during. The Fed s interest rate hike signals a stronger U.S. economy and that is positive for Canada. With the Canadian economy on a weaker growth trajectory than the U.S. economy, the Bank of Canada will not be following Fed rate hikes any time soon. Most recent U.S. economic data December data indicated a loss of growth momentum in the manufacturing and services sector. The seasonally adjusted Markit Flash U.S. Composite PMI Output Index slowed to 3. in December, down from.9 in November. Manufacturing is feeling the impact of low oil prices through reduced investment demand for plant and machinery and the stronger dollar is affecting exports. Many service sectors such as transport and business services are dependent on manufacturing as well. Real GDP growth in is tracking just under two per cent annualized according to the Atlanta Fed s GDPNOW model and Moody s Analytics High Frequency GDP model. The median expectation of more than 60 forecasters is 2.0%. real GDP currently sits at 2.3% with at 3.9%. For all of, real GDP growth looks to come in near 2.2%, slightly slower than 2.4% in Most forecasts, including the Fed s, have growth edging higher to around 2.% in and near the same pace in. The U.S., and to a lesser extent the U.K., are on different monetary paths than many other countries because of differing economic circumstances. Europe s economy is undergoing a modest expansion and growth will likely come in around 1.%, with considerable monetary stimulus in place possibly another injection in. Japan is in a similar situation with weak domestic conditions and very accommodative monetary conditions. Japan s export sector is its main hope for a growth uplift, and without a pickup in China, more domestic policy measures are likely = Exchange Rate: U.S. Trade Weighted Broad Index Source: U.S. Federal Reserve. China s policy moves Note: year-to-date average to Nov. China s central bank cut its benchmark rate six times in and lowered the reserve requirement ratio three times. Further monetary and fiscal stimulus moves are likely in. China s economy is showing some signs of reversing its downward growth momentum in place since China s industrial sector improved somewhat in November, with both industrial production and fixed asset investment showing stronger growth following recent lows in September. Retail sales were up in November and housing activity rose. It is too early to declare an end to China s growth slump but past and new stimulus measures will help. Nonetheless, its medium and longer term growth profile will be much lower than in the prior decade due to various structural forces. In November, the IMF announced that China s currency will be included in the Special Drawing Rights basket commencing in October. Its share at 10.9% will be larger than both the Japanese Yen and British Pound in the new basket. Other currencies in the SDR basket are the U.S. dollar and the Japanese yen. While a debatable decision in the eyes of some on the freely usable criterion, the IMF s move recognizes China s large and dominant role in the global economy. Another currency development was China s plan to track the yuan relative to a trade-weighted currency basket rather than of a peg to the USD only. It would serve as a reference guide though in reality it could be used to adjust the yuan s value. The new index includes 13 currencies 2

3 with the USD given a weight and the euro Last August, the yuan was devalued two per cent relative to the USD, and with more USD appreciation on the horizon, the reference basket gives the authorities plausibility to deny currency manipulation, i.e., additional yuan devaluations which are likely. Growth in other emerging economies remains slow and broadly based with India the best big emerging economy performer. Brazil and Russia are struggling in deep recessions while South Africa flirts with recession. The energy and mining downturn has a considerable negative impact on these economies with repercussions around the world. Slow uneven growth Turning to Canada, real gross domestic product fell 0. per cent in September, mainly the result of declines in mining, quarrying, and oil and gas extraction and, to a lesser extent, manufacturing. This came on the heels of three consecutive monthly increases. Expenditure-based real GDP rose for the first time in two quarters with a 2.3 per cent annualized increase in the third quarter, ending the rule-of-thumb recession. Households, residential, and an export rebound were behind the gain while business investment contracted further. October industry real GDP is expected to post a small gain partly because the temporary production difficulties and maintenance shutdowns experienced in September will have passed and the hiring ramp-up for the federal election. However, manufacturing sales fell in October as did wholesale sales. Ongoing weakness in energy and mining has negative spillovers into manufacturing and other sectors such as business services. To no surprise, the household sector is holding up. November housing market data were strong with sales and prices rising. New vehicle sales also performed well. Employment decreased by 36,000 persons in November following a similar-sized increase in October. Employment in public administration declined by 33,000 in November, offsetting an increase of 32,000 in October due to the federal Canada s Economic Growth Per cent change at annual rate Real GDP Final Domestic Demand Source: Statistics Canada. Note: Expenditure-based GDP. Latest: - election. Overall employment growth is trending less than one per cent in. Inflation in Canada came in at 1.4 per cent in November while the Bank of Canada s core index was 2 per cent higher than one year ago. Low energy prices are pulling down headline inflation while core inflation was held up by the currency effect and the exclusion of key energy components. Fourth quarter real GDP is tracking lower than the Bank of Canada s 1. per cent real GDP forecast. Our forecast is 1.0 per cent with downside risks. For all of, growth will come in close to 1.0 per cent. Next year s forecast is 1.8 per cent, slightly lower than the Bank s expectation, though the Bank could trim it lower at its next update in the January Monetary Policy Report. Exports and the manufacturing sector need to progress on a more sustained basis in order to lift Canada s growth above 2. per cent. The lower Canadian dollar should strengthen exports but this takes several years and in the meantime volatility looks to continue. Overall, moderate growth and a tighter labor market are expected in. Rates on hold, lower CAD The Bank of Canada is expected to remain on hold through until around mid-. However, recent data and oil price declines raise the risk of another rate cut or insurance policy move at the January 20 meeting or possibly at the March 9 meeting. The futures market is pricing in about a 2 per cent chance of a rate cut. 3

4 In a recent speech, Governor Poloz outlined the use of negative interest rates as one of four unconventional monetary policy measures it would use if faced with a major economic crisis. The other three are forward guidance, large scale asset purchases (QE) and funding for credit. Negative interest rates are the last policy option though all four could be used simultaneously should conditions warrant and such conditions would be dire indeed. There is considerable downside pressure on the Canadian dollar due to the confluence of low oil and other commodity prices and diverging economic and monetary paths with the U.S. A fall below 70 US cents is possible and increasingly likely in the next three to six months. Crude oil prices have not bottomed and the Fed will normalize at least once more before mid-. Helmut Pastrick Chief Economist, Central 1 Credit Union U.S.-Canada Exchange Rate, Daily U.S dollar per Canadian dollar /01/ /07/ /01/ 02/07/ Source: Bank of Canada. Latest: Dec. 21, Target Overnight Rate Forecast Meeting Date (Per cent) Dec. 2 (a) 0.0 Jan. 20, 0.0 Mar Apr June July Sep Oct Dec Jan. 0.0 Mar. 0.0 Apr. 0.0 June 0.7 July 0.7 Sep. 0.7 (a) actual 4

5 a Interest Rate Forecast Target Overnight Rate Prime Rate mo. T-Bill mo. T-Bill mo. T-Bill year T-Bill year GoC Bond year GoC Bond year GoC Bond year GoC Bond Source: Bank of Canada, Central 1 Credit Union forecasts. Note: Quarterly average based on daily data. a = actual, all others forecast. a Deposit Rate Forecast 1-year GIC year GIC year GIC Source: Bank of Canada, Central 1 Credit Union forecasts. Note: Quarterly average based on weekly data. a = actual, all others forecast. Non-redeemable semi-annual rates from Bank of Canada based on typical rate (mode) at six major banks. a Mortgage Rate Forecast 1-year Mortgage year Mortgage year Mortgage Source: Bank of Canada, Central 1 Credit Union forecasts. Note: Quarterly average based on weekly data. a = actual, all others forecast. Posted fixed term rates from Bank of Canada rates based on typical rate (the mode) at six major banks.

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