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The Bank of Canada has delivered a 25bp cut for the second consecutive meeting, talking policy rates from 4.75% to 4.50%, in line with market consensus and our own pre-announcement call.
The pace of BoC cuts to date leaves it at the head of the easing pack, neck-and-neck with the SNB, ahead of the ECB and the Riksbank, with all other G10 central banks still in the starting blocks. Moreover, the Governing Council used its latest communication to reiterate that further cuts are likely if inflation continues to ease in line with expectations. Given our own view of the Canadian economic outlook, which as we have pointed out for some time now, appears grim, we look for a further rate cut in September, and 2-3 further cuts in total this year.
The upshot is that rate differentials between Canada and other major economies are likely to continue growing in the short term. As such, while today’s decision has seen USDCAD temporarily nudge above 1.38, we think the pair should continue to run higher over the coming months.
Turning to the details of today’s decision, the key line once again came in Governor Macklem’s opening statement, saying: “If inflation continues to ease broadly in line with our forecast, it is reasonable to expect further cuts in our policy interest rate. The timing will depend on how we see these opposing forces playing out. In other words, we will be taking our monetary policy decisions one at a time.” We not only think this keeps the door open to potentially cutting rates at every meeting this year, but given a dovish shift in the Bank’s characterisation of risks, with Macklem suggesting that “the downside risks are taking on increased weight in our monetary policy deliberations”, we think a similar view is now shared the Governing Council as well. Indeed, when given an opportunity to reject such an idea in the Press Conference, the Governor demurred.
The contents of today’s MPR support this view too, also skewing dovish in our eyes. Specifically, Bank staff now estimate the output gap lay between -0.75% and -1.75% in the second quarter, roughly unchanged from Q1, although the first quarter figure was revised 0.2 percentage points lower reflecting weaker-than-expected growth.
Similarly, changes to the Bank’s inflation forecasts were also dovish on net. Admittedly the 2024 forecast was left unchanged at 2.6%, while the 2025 forecast was lifted from 2.2% to 2.4%, but this appears to reflect gasoline base effects. On a fourth-quarter-over-fourth-quarter basis, however, price growth is now predicted to run at 2.0% YoY in 2025 and 2026, with both seeing downgrades of 0.1pp relative to the previous MPR. Underlying inflation is also expected to cool, with Bank staff projecting the average of CPI-trim and CPI-median inflation will settle at 2.0% next year.
While the Bank’s latest communications suggest increasing confidence that inflation is on its way back to target, helped by excess slack and a softening labour market, it did flag some upside price growth worries.
As noted in the policy statement and echoed in Governor Macklem’s opening remarks, “Shelter price inflation remains high, driven by rent and mortgage interest costs, and is still the biggest contributor to total inflation.” Even so, we would add that cutting rates will naturally see those costs fall – a point also alluded to by Senior Deputy Governor Rogers during the press conference, meaning that this really shouldn’t be a concern. Taken as a whole then, we think markets are under-pricing the risks of a September rate cut, with odds currently standing at 60%. We look for at least two more rate cuts over the remainder of the year, with three likely if the inflation data permits.
Either way, rate differentials between Canada and many other G10 economies should widen in the coming months, setting the scene for further loonie underperformance.
Author:
Nick Rees, FX Market Analyst