Fed Postpones Rate Hike

The Fed kept the overnight rate unchanged today, choosing to delay an increase owing to stubbornly low inflation, an uncertain outlook for global growth and recent financial market volatility. It appears that recent losses in China's equity markets reflect deeper worries over growth prospects for the world's second largest economy. Slowing growth in China has helped to trigger a dramatic drop in commodity prices, especially oil, which has put further downward pressure on U.S. inflation.

Currently, inflation in the U.S. over the past twelve months is only 0.3 percent, well below the Fed's target of 2 percent. Much of this is owing to the strengthening in the U.S. dollar and falling commodity prices. Also, despite tightening labor markets, wages gains have remained extremely muted.

By holding the benchmark federal funds rate at zero to 0.25 percent, policy makers revealed their continuing uncertainty that inflation has not moved back to their 2 percent target, despite gains in the labor market. The Committee expects inflation to remain low for many months.

Federal Open Market Committee (FOMC) members revised down their expectation of unemployment this year and next to a few basis points below the current level of 5.1 percent. Inflation expectations were revised down, as were projections of the federal funds rate even though growth is expected to perform well.

Most participants expect the Fed to raise interest rates this year, although four Committee members expect the first increase to be delayed to 2016. Richmond Fed president Jeffrey Lacker dissented with the Committee's decision, saying he preferred to raise the target rate by 0.25 percentage points now.

Concern was expressed regarding global economic uncertainty. Clearly, the slowdown in China has caught the Fed's attention. Headwinds from abroad are affecting the Fed's forecast. The federal funds rate is not expected to return to "normal" levels until the end of 2018. So when interest rates do rise, they will do so only gradually.

The median of the Fed's long-term forecast was lowered to 3.5 percent from 3.8 percent in June. The Fed is forecasting a federal funds rate of 0.4 percent for 2015, 1.4 percent in 2016, 2.6 percent in 2017 and 3.4 percent in 2018, which all are lower than the central bank saw in June. The central bank projected less inflation, trimming its forecast for inflation this year, 2016 and 2017, and not seeing inflation reach the 2 percent target until 2018. At the same time, the Fed got more optimistic on the unemployment rate, lowering its projections for 2015, 2016, 2017 and the longer term.

This is good news for Canada where the economy is  much weaker than in the U.S. and where the Bank of Canada is at least a year away from tightening. Chairman Yellen mentioned Canada specifically in her press conference, suggesting that the slowdown in Canada arising from the oil price rout is important as Canada is "an important trading partner" with the U.S. Clearly, interest rates will remain low for a long time and when they do rise, they will do so only gradually.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres

Bank of Canada Maintains Rate

As expected, the Bank of Canada refrained from cutting interest rates at today's policy meeting. The recent economic news has shown a marked improvement, precluding the Bank from following on the previous two rate cuts this year. The key policy overnight rate is only 50 basis points (one-half of one percentage points) and another 25 basis point (bp) cut would only reduce the Bank's ability to take action, if needed, in the future.

The slowdown in the Canadian economy in the first half of this year had nothing to do with interest rates and had everything to do with the massive decline in oil prices. As the Bank has noted, "financial conditions are accommodative and provide considerable support to economic activity".

In addition, a 25 bp rate cut would only translate into a 12-to-15 bp cut in mortgage and other consumer and business borrowing rates, as we have seen with the January and July cuts. The reason is the cost of funds for the lenders has risen relative to risk-free government five-year bond yields--normally linked to mortgage rates--as investors risk appetites have declined. This rise in so-called credit spreads reduces the stimulative effect  of any rate cut by the Bank of Canada.

Moreover, the interest-sensitive sectors of the Canadian economy--housing, autos and other durable goods purchases--are already booming. Business investment has declined sharply, but only in the oil patch, which would not be reversed by lower interest rates. Another rate cut would only encourage increased household indebtedness and, at the margin, make little difference.

The good news is that the U.S. economy has rebounded sharply from the first quarter slowdown, with second quarter growth of 3.7 percent surprising on the high side. This has helped to boost Canadian exports, particularly for autos and aircraft. As the Bank expected, the weaker Canadian dollar has spurred the demand for Canadian products in the U.S. and elsewhere.

To be sure, the Chinese economy has slowed, putting downward pressure on certain commodity prices important to Canada's exports, but the pick up in the U.S. has finally provided a meaningful offset.

The Bank of Canada is at last seeing the stimulative effects of its earlier rate cuts and is confident that the five-month decline  in economic activity has halted with the stronger-than-expected 0.5 percent growth in June. The increase in June was broad-based. Also, more recent data show a strong uptick in employment growth. Third quarter GDP growth is in train to meet or exceed the Bank's forecast of 2.5 percent, a welcome reversal of the first-half slide.

While core inflation has been about 2 percent, the Bank judges that the underlying trend in inflation remains at about 1.5 to 1.7 percent.

To be sure, the heightened volatility in financial markets, the slowdown in emerging economies and the potential further decline in oil prices will keep the Bank ever watchful. If the rebound in economic activity peters out later this year, which I doubt, the Bank will act quickly to cut rates once again. The next policy announcement date is October 21, just two days after the Federal election