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The Bank of Canada met our expectations in holding the policy rate at 5% today, a decision that was unsurprising to most observers given the steep drop in last week’s GDP data.
Despite keeping the policy rate steady, the Bank retained a hawkish bias given the lack of progress on core inflation, and noted that the policy rate could increase further if needed. What the Bank didn’t say was probably more telling than what they said, though. The rate statement had no reference to downside growth risks, the fact that the output gap has turned negative, nor the deteriorating trade balance, which are major reasons underlying our long-standing call for no further hikes this year. Furthermore, officials clearly view the economic slowdown as overstated by temporary factors given their reference to wildfires depressing economic activity, and they seem a touch too pessimistic on the rebalancing of wage growth by focusing on the elevated year-on-year rate rather than the clear slowdown in sequential momentum. One key change to the statement was the discussion around inflation, which now mentions that prices could briefly pick back up because of a rise in gasoline prices, although we don’t view this as particularly significant as the Bank almost always looks through energy shocks.
We think the Bank retained such a hawkish bias for a few strategic reasons. The persistence in core inflation measures is a strong argument for preserving optionality, and sounding too dovish could lead to premature loosening of financial conditions as markets would price in cuts, which would make the final stretch of the inflation fight more challenging. But even then, we think the Bank sounds a bit too pessimistic on the underlying drivers of inflation, which in our view should lead to a near-term turnaround in core price pressures.
The BoC has repeatedly mentioned that excess demand, inflation expectations, wage growth, and corporate pricing power will guide the path forward for policy. Well, excess demand has been eliminated, 5-year inflation breakevens are well-anchored around 2%, sequential momentum in wage growth has come to a screeching halt, and margins continued to compress throughout Q2. We therefore continue to expect no further hikes this year, but the risks to our call tilt to the upside and are concentrated around the October meeting.
Bank of Canada’s “four pillars” suggest core inflation will slow
Evidence around the four main areas that the Bank of Canada is watching to guide policy generally suggest that core inflation pressures will subside in the near term. First off is the evolution of excess demand. The latest GDP report noted that the economy contracted ever so slightly in the second quarter, by -0.2% annualised, while the Q1 figure was downgraded from 3.1% to 2.6%. With such a weak growth figure, the economy is running well below the Bank’s estimated range for potential GDP growth, which is currently assumed to be between 1.4% and 3.0%.
The BoC will undoubtedly need to downgrade its growth forecasts in the next Monetary Policy Report, and it will struggle to argue that excess demand still lingers in the economy.
Growth is now running below potential after sharply missing forecasts
Inflation expectations are also quite stable and are tracking almost perfectly in line with the Bank’s 2% target. Compared to some of the other pillars, though, the evidence is a little murkier. The best metrics we have are from the Bank of Canada’s twin business and consumer surveys, and neither of those has been updated since the first quarter. We can use market-based inflation breakevens as a proxy, with the caveat that real return bonds are no longer being issued by the federal government, and the resulting lack of liquidity makes the read-through a bit less reliable than it used to be. At face value though, the latest reading of 2.05% on the 5-year breakeven, and its relative stability throughout 2023, suggests that inflation expectations are firmly anchored and on target.
The recent rise in gasoline prices could lead consumer expectations to pick back up in the short term, but with OPEC+ oil production cuts scheduled to end in December, we expect this to be temporary.
Inflation expectations are firmly anchored around 2%
The labour market is also rebalancing well. Wage growth is indeed running above the pace consistent with 2% inflation if you focus on year-over-year rates. Average hourly earnings printed at C$33.24 in July, which was 5.02% higher than a year earlier. But this doesn’t consider the fact that nominal wages are running slightly below their April peak of C$33.38, nor that the 3-month moving average of wage growth was -1.7% on an annualised basis. The labour market is still quite hot compared to historical norms, but job gains are now slower and less consistent than they were at the start of the year and the most recent jobs report pointed to clear weakness in hiring for core-aged workers, which has led to an 0.5pp increase in the unemployment rate since the start of the year.
With population growth being abnormally high and hiring intentions declining, we anticipate wages to come under further pressure from both the supply and demand sides of the labour market.
Wage growth has tapered off in recent months
Last but not least, margin compression is under way. As with inflation expectations, the evidence on corporate margins is fairly sparse in Canada, especially compared with the US and other advanced economies. While this is not representative of the entire economy as many firms are privately held, the operating and profit margins for TSX-listed companies clearly exhibit a downward trend. Furthermore, public companies have reported in recent earnings calls that they broadly expect consumer demand to slow, which will put further downward pressure on margins.
While these margins are still elevated on a historical basis, the trend is encouraging for core inflation given that price competition for market share will become an even more prevalent theme as we round out the end of the year.
Margin compression is under way
With these indicators suggesting that downward pressure on core inflation will amplify, all we can do now is wait and see whether this materialises in the hard data, and there will be plenty for the BoC to digest between now and October. We are scheduled to receive another monthly GDP print, along with two inflation reports, two jobs reports, and two of almost every second-tier data release before the next meeting on October 25th. Not only that, but the Q2 editions of the Business Outlook Survey and the Canadian Survey of Consumer Expectations will be hot off the presses shortly before the decision. With so much data set to arrive by October, the Bank should have a clear indication by then as to whether they can finally call the end of the hiking cycle or not.
If growth stagnates or turns recessionary, weighing on underlying inflation, consumer inflation expectations subside in the CSCE, wage growth stays on trend, and margins continue to shrink, the Bank of Canada will have the “all clear” to officially announce no further hikes.
Author:
Jay Zhao-Murray, FX Market Analyst