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The Bank of Canada raised its policy rate by 25bps to 5% as expected, its highest level in 22 years. As we anticipated in our preview, the Bank remained firmly committed to the new narrative it relayed in June around more robust growth conditions and the threat it posed in terms of inflation persistence, despite a month’s worth of less uniformly strong data.
Within the rate statement, the Bank highlighted “surprisingly strong” consumption growth, the pickup in housing, and labour market tightness as the key areas within the economy to justify today’s follow-up hike, while it also decided to reintroduce reference to the 3-month annualised measures of core inflation which have been averaging 3.5-4% since September.
Owing to this, the latest set of forecasts now sees the inflation target being reached 6 months later in mid-2025 despite being predicated on a policy rate that is 50bps higher.
Upon the release of the data, money market expectations shot higher, immediately pricing an 83% chance of an additional hike in September. This helped the loonie double the gains it made against the greenback an hour and a half prior on a soft US inflation reading, with CAD now 0.55% stronger on the day. During the press conference, however, Governor Macklem’s greater emphasis on the need to balance the risk of over and under-tightening led markets to reprice those odds lower to 66%, although the loonie hung on to most of its gains. While we were more optimistic than the market on the prospect of hikes in June and July, we now think that markets have overpriced the risk of a third follow-up hike. Between now and September, we expect to see a gradual slowdown in the momentum of the Canadian economy over several months of data, helped by a slowdown in the US as well, which will likely allow officials to stand pat at 5% this year before beginning to ease policy in the first half of next year. Regardless of whether the BoC delivers the hike the market expects or not, Macklem’s comment that “we think we’re close” to getting inflation back to target is a clear sign that the tightening cycle is nearly over.
Looking ahead, while we think the BoC will end its hiking cycle at the current policy rate of 5%, we think there is more upside policy risk in Canada than in the US, owing to the greater degree of inflation persistence. Until the Canadian data uniformly turns and begins to represent the current conditions in the US, we remain bullish on the loonie over the near term, with a three-month target of 1.30.
USDCAD approaches recent lows following BoC decision and US CPI
Officials focused on explaining June’s decision, not the data
The key thing to understand about the Bank of Canada is that, while officials obviously pay considerable attention to the data, the story communicated to the public always comes first. Of course, every claim must be backed by evidence, but when that evidence is murky, the Bank has leeway in choosing what they emphasise or ignore, and this is especially the case with inflation given the vast number of ways to measure it. Officials came out with a strong view in June that the economy was both more robust and generating more inflationary pressures, promising to elaborate on that view in today’s Monetary Policy Report. They followed through on that promise today, as losing confidence in their view after only a single month would have been a communications disaster. It is for this reason that we had confidence before ever seeing the latest data that the Bank would hike today, as it would have taken irrefutable evidence that the economy was in dire straits for them to have done otherwise, which we thought was unlikely. The data released over the last month had something for both the hawks and the doves, with GDP, inflation, and jobs all appearing to soften on the headline but coming with caveats and details that suggested more underlying strength. For instance, GDP came in flat in April, but was led lower by the public sector strike, headline inflation fell by a full percentage point to 3.4% in May, but energy base effects were the reason, and the first supposed job losses in months were actually driven by issues with StatsCan’s seasonal adjustment model.
The fresh evidence since June was mixed enough that if they hadn’t hiked in June, they could have also argued the opposite case today. By September, however, the Governing Council will have had a full quarter’s worth of data since the decision to abandon the pause. If leading indicators such as the Business Outlook Survey for Q2 are to be trusted, the data should begin to cool at the margin, led by easing levels of labour demand and continued population growth.
This combination should weigh on wage pressures, demand conditions, and corporate pricing power as a result, reducing the threat that inflation pressures remain embedded in the economy, and given Canada’s deep trade ties with the US, a slowdown to the south is yet another reason to think that the data will turn. In fact, the Bank’s own forecast of GDP growth for 2023, at 1.8%, sits below their estimate of potential output, meaning that the output gap should turn negative and put downward pressure on prices.
Interestingly, the July MPR contradicted a point Deputy Governor Beaudry made last month, when he was posed a question about the extent to which government spending was making the central bank’s job more difficult. Despite fiscal authorities considerably overshooting their own spending projections, Beaudry argued that government spending was at a level that was neither inflationary nor disinflationary. The MPR, however, notes that “fiscal measures in recent federal and provincial budgets” were one of five reasons offered to explain the unexpected strength of household spending in H1, and obviously the lack of progress on core inflation since last summer may have something to do with the Q1’s consumption growth of 5.8%. The other four reasons offered were the tightness of the labour market, increased immigration, accumulated household savings, and pent-up demand for services.
“What we’re saying now is we’re taking one decision at a time
What has been notable in the Bank of Canada’s communications in recent months is a sense of optimism over their ability to orchestrate a soft landing. This stands in direct contrast with the likes of the ECB and the Bank of England, where policymakers have stressed their preference to overtighten now and correct for the side effects later. Today’s press conference by Governor Macklem didn’t usher in a change in stance, despite it being his first public appearance since the BoC resumed its hiking cycle back in June. When repeatedly asked, Macklem reiterated his argument that the BoC aims to “balance the risks of over and under-tightening,” emphasising both the persistence in inflation and robust nature of demand alongside uncertainty over the lagged impact of past hikes.
For markets, this did little to tip the balance in either direction, leaving the possibility of a hike in September or in Q4 subject to how the data evolve.
What is noteworthy, however, is that while the upgrades to the inflation projection have set the stage to underpromise and overdeliver on bringing inflation down. At first glance, saying that inflation will return to target in two years’ time appears to suggest the need for further tightening, but in reality, inflation will probably return to 2% at some point in 2024. Officials are effectively setting themselves up to make the argument in September that inflation pressures have undershot expectations, the risks of overtightening have grown, and that no further hikes are needed.