The market has priced in a rate increase, but will the Bank of Canada deliver?

As of late Tuesday afternoon, markets and analysts were indicating there was a 92 per cent chance the Bank of Canada would on Wednesday announce that it will hike its overnight interest rate target by 25 basis points to 0.75 per cent.

But just how can bankers and economists be so precise in their expectations? Just where do those odds come from?

The answer has to do with the way the BoC actually implements its policy interest rate.

Major banks and financial institutions are constantly transferring funds to one another in something called the Large Value Transfer System.

“Overnight” market

Banks need to settle those large transactions each day. If a bank is short, it can briefly borrow the funds it needs in an “overnight” market. The interest rate for this overnight market fluctuates with supply and demand, but trades within an “operating band” set by the BoC. The bank’s “target rate” sits at the centre of this operating band.

This is the policy rate you see making all the news, because it influences a host of other market rates, such as consumer loans and mortgages.

Because that overnight target rate fluctuates, traders are willing to make deals to swap the current overnight rate for a future fixed interest rate. If they expect the BoC is about to hike its target interest rate on Wednesday, the fixed rate they’re willing to swap should embed that expectation in the price they’re willing to pay. This bakes the price-hike into the market — and it makes it possible to quantify just how certain the market thinks that change is likely to happen.

“When you back it out from those contracts, you get what the market is predicting to be the probability of change in the rate,” said Derek Holt, vice-president and head of Capital Markets Economics at Scotiabank.

On Wednesday morning, we’ll see whether the market’s gamble was on the money.

Monetary policy

We’ll also see what the BoC has to say about it all. In addition to announcing the policy rate, the Bank is also releasing its latest quarterly Monetary Policy Report, which will detail the bank’s latest projections for Canadian inflation and growth.

The inflation outlook will be crucial. Recent data says the country has one of the strongest performing economies in the developed world, yet Canadian inflation has remained quite low.

Until just a few weeks ago, top BoC officials had been talking about the “slack” that was still present in the economy, suggesting that low interest rates were needed to stimulate growth. That tone has recently and abruptly changed, and leading most private sector economists to conclude the bank no longer sees a need for the stimulus.

“When you look at the economic data, it’s pretty clear that the economy doesn’t need 0.5 per cent interest rates to grow at an above-trend pace,” said Nathan Janzen, a senior economist with RBC Economics. If the Bank raises the rate to 0.75 per cent, that’s still relatively low, Janzen said. “You can have higher rates and still have very stimulative monetary policy.”

In fact, economists sense that even if inflation remains low, Canada’s economy has been growing so fast that the Bank might see the need to start raising rates now to prepare for a pick-up in inflation that might come later.

“The thing that worries me is that we’ve averaged about three-and-a-quarter per cent GDP growth per quarter for four quarters now,” Holt said. “The risks of maintaining overly easy monetary policy for much longer are probably outweighed by the risks of not taking a little bit of a step in the opposite direction.”

Financial Post
dhasselback@nationalpost.com
twitter.com/vonhasselbach