Dovish Fed, hawkish BOC

Janet's in the house. US Fed Chair Janet Yellen's much-awaited testimony did not differ greatly from what was already divulged in the FOMC statement released on 14 June - when the Fed raised the fed funds rate by 25 basis points to 1%-1.25%.

In her prepared remarks before the House Financial Services Committee, Yellen reiterated her positive outlook on US growth:

"Ongoing job gains should continue to support the growth of incomes and, therefore, consumer spending; global economic growth should support further gains in US exports; and favorable financial conditions, coupled with the prospect of continued gains in domestic and foreign spending and the ongoing recovery in drilling activity, should continue to support business investment. These developments should increase resource utilisation somewhat further, thereby fostering a stronger pace of wage and price increases."

...and her doubts about inflation:

"There is, for example, uncertainty about when and how much inflation will respond to tightening resource utilisation."

Nonetheless, she offered a dovish forward guidance, stating that while the current level of the fed funds rate "remains somewhat below its neutral level ... the neutral rate is currently quite low by historical standards" and therefore, "the federal funds rate would not have to rise all that much further to get to a neutral policy stance."

It was different across the border. The Bank of Canada's (BOC) decision to lift its benchmark rate by 25 bps to 0.75% overnight came as no surprise to financial markets. This was telegraphed in late June by BOC chief Stephen Poloz when he commented that interest rate cuts "have done their job" and that excess slack in Canadian economy being absorbed. What wasn't communicated was the BOC's hawkish forward guidance.

Canada's GDP expanded by 2.3% in the year to the first quarter of 2017, accelerating from 2% in the previous quarter. The BOC now projects GDP growth of 2.8% in 2017, 2% next year and 1.6% in 2019. More importantly, "the output gap is now projected to close around the end of 2017, earlier than the Bank anticipated in its April Monetary Policy Report (MPR)" - when it predicted the output gap to close in the first half of 2018.

Reason perhaps why the BOC is not taking chances despite slowing inflation - headline CPI inflation eased to 1.3% in May from 1.6% in April; core CPI inflation eased to 0.9% from 1.1%. Besides, "the factors behind soft inflation appear to be mostly temporary, including heightened food price competition, electricity rebates in Ontario, and changes in automobile pricing. As the effects of these relative price movements fade and excess capacity is absorbed, the Bank expects inflation to return to close to 2%t by the middle of 2018."

Moreover, as BOC governor Poloz explained: "It is worth remembering that it can take 18 to 24 months for a monetary policy action to have its full effect on inflation. This means that central banks must target future inflation by anticipating future deviations from target."

Fair enough. Hopefully the BOC doesn't repeat the events of 2010 when it raised interest rates when it raised interest rates by 25 bps each in June, July and September of that year from 0.25% to 1%. After a lag, headline inflation was brought back down from a high of 3.7% in May 2011 to a low of 0.3% in April 2013.

Certainly, those were turbulent years in the global economy - European debt crisis among others - but perhaps, more directly related to Canada, the rate hikes in 2010 slowed GDP growth from a peak of 3.7% in the year to the September of 2010 to a mere 0.5% in the year to the December quarter of 2012 that, in turn, contributed to the deceleration in measured inflation, prompting the BOC to lower interest rates again in 2015.

Hopefully, the Canadian central bank has learnt its lesson and would remove policy accommodation more gradually this time.

Read more: BOCBank of CanadaStephen PolozApril Monetary Policy ReportHouse Financial Services CommitteeUS Fed Chair Janet Yellen
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