The Bank of Canada raised its policy rate on Wednesday by 50bps to 3.75%, missing consensus and market expectations for 75bps but coming in line with our forecast.
Although the Bank noted that the Canadian economy remains in excess demand territory with a tight labour market, its decision was predicated on a sharp downgrade in its growth projections, which now see the economy stalling later this year and into the second half of next year. That downgrade was especially tied to the “significant” pull-back in housing activity. Today’s decision highlights how growth and financial stability considerations are having a larger role in the policy debate within the Governing Council, a dynamic that we expected now that the policy rate is in restrictive territory.
While the rate statement primarily pointed to slowing housing-related activity and slowing external demand conditions to justify its lower growth outlook, it also referenced a broad range of slowing sectors within the economy, including diminished investment plans and household spending in both goods and services.
On its projections, the Bank downgraded its path for GDP across the entirety of its forecast horizon, with the cut to 2023 growth expectations from 1.8% to 0.9% standing as the largest revision.
With potential growth estimated at just over 2% for 2023 and 2024, the lower growth outlook going forward suggests that the positive output gap will soon shrink, which calls for a more cautious pace of policy tightening going forward, especially if a recession is to be avoided.
On the inflation front, the Bank downgraded its Q3 CPI forecasts by a substantial margin, from 8.0% to 7.2% YoY. It also added a brand new forecast for Q4, which suggests price pressures will only marginally slow to 7.1% YoY. Looking further out, the Bank expects inflation to remain above target next year, with a year-end rate of around 3%, before falling back to the 2% target by end-2024.
Despite the downshift from September’s 75bp hike, 50bps is still a hawkish move in the broader historical context, where 25bp-sized moves were the norm. Given the Bank’s judgement as to the state of the output gap, which is positive and putting upward pressure on inflation, officials continued to guide markets towards higher rates, noting in the statement that “the Governing Council expects that the policy rate will need to rise further.”
We now expect another downshift to 25bps in December before a pause to wait and see how the data evolves, which would bring the overnight rate to 4% by year-end.
In their immediate response to the data, Canadian bond yields repriced dramatically. The yield on the 2Y note fell 24.1bps, while the 10Y dropped 23.5bps. That placed downward pressure on the loonie, sparking a knee-jerk 0.25% rally in USDCAD. Canadian equity futures trimmed back slightly but remained positive on the day. The initial reaction in the loonie quickly reversed as the continued decline in Canadian bond yields spread to core yields, spurring another wave of risk-on price action in cross-asset markets. As this spurred another leg lower in the broad dollar, USDCAD started to fall, however, the loonie did remain the laggard in the G10 space due to the dovish repricing.
Dramatic drop in Canadian 10-year yield spurs a leg lower in the dollar and a rally in the loonie
During the press conference, Governor Macklem noted that the Bank is nearing the end of its policy tightening cycle, as it is now “balancing the risks of under- and over-tightening.
This marks a sharp divergence from his comments in recent months, which have been unanimously focused on tackling inflation. In addition to that, Macklem drip-fed a few more pieces of new information. For instance, he specifically highlighted the three-month moving average of sequential core inflation as a key indicator to watch and placed a heavy emphasis on the BOS and CSCE surveys. Based on our readings of those surveys, the BOS showed more disinflationary signals, while the CSCE was less clear. Given the Bank’s 50bp decision today, revealed preference suggests that officials are placing a stronger weight on the information in the business survey, rather than the consumer one. Macklem also downplayed the impact of imported inflation stemming from CAD depreciation, despite mentioning that risk in recent public comments.
With regards to the future path of the policy rate, the Governor hinted strongly that 25bps is the current working assumption for the next hike.
That said, he was ambiguous enough to keep his options open, and further mentioned that he would prefer a gradual end to the tightening cycle as opposed to an immediate pause followed by further tightening next year. Macklem’s comments imply an upside risk of 50bps in December to our 25bp call, as the decision will heavily depend on the incoming data, but they also make it highly unlikely that the decision will come down to anything outside of 25 or 50bps.
Jay Zhao-Murray, FX Markets Analyst