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The Bank of Canada today cut its overnight policy rate by 25bps to 4.75%, having previously held rates at a terminal level of 5% since July last year.
The decision to cut rates didn’t necessarily come as a surprise, seeing as the two inflation reports since April’s meeting have met the Bank’s qualification of “sustained” progress. Moreover, the totality of Canadian data since the BoC last met has been unequivocally weaker than the Bank forecast, with the unemployment rate now back at levels last seen in 2017 and growth continuing to underperform the Bank’s estimates of both realised and potential output in Q1.
The Bank of Canada began to dial back its monetary restrictiveness having seen inflation pressures ease further in April
While BoC policymakers could have found reason to hold rates, against its previous guidance, on the basis that Q1 consumption growth was strong at an annualised rate of 3%, and April’s jobs report suggested this is filtering through into stronger employment demand, this would have been a mistake.
Underlying economic momentum has remained weak following a strong expansion in January and February, and while April’s flash GDP number suggested the economy picked up momentum at the start of the second quarter, there is little sign that this is disrupting the overall trend of disinflation. This was pinpointed by Governor Macklem today, who framed the increase in consumption as merely in line with overall population growth, rather than the contraction in per capita consumption visible throughout the middle months of 2023.
Moreover, the Governor noted that this is having little bearing on the overall path of inflation, with all measures now back within the Bank’s tolerance range, underlying momentum suggesting further disinflation progress is likely, and the fact that the economy is now operating in better balance.
Should this remain visible within the two upcoming inflation reports before July, back-to-back rate cuts are a reasonable assumption according to Governor Macklem. We are somewhat more sceptical and expect the Bank to display caution around cutting too aggressively given risks of an excessive easing in financial conditions prior to the first cuts from the Fed; a stance that has been adopted by both the Swiss National Bank and the Swedish Riksbank, the two G10 central banks to cut before the BoC.
Instead, we suspect the Bank will want to cut rates at every other meeting until the fourth quarter, leaving them to cut only twice before the Fed embarks on its first reduction on September 18th, as per our base case.
That said, as we noted following the BoC’s decision to hold back in April, that by delaying the decision to ease in order to obtain greater confidence over the path of disinflation, the Bank risked sitting too far behind the curve and needing to aggressively ease policy to prevent inflation falling back below target later in the year. This risk remains prominent, especially if the labour market continues to unwind. Should May’s jobs report at the end of the week highlight that further slack is emerging in the labour market, either through downward revisions to April’s employment numbers or a mean reversion in the pace of employment growth, markets should settle on the idea that the BoC will conduct two more rate cuts over the course of the third quarter seeing as momentum alone supports further disinflation.
Such a stance is unlikely to come up against any resistance from the BoC either given that Governor Macklem reaffirmed his view from May, that divergence in rates form the Fed isn’t yet at levels that is concerning policymakers, when speaking to the press today.
All told, while the delivery of today’s rate cut and the acknowledgement of further easing has led USDCAD and Canadian rates to converge with our base case, markets are yet to fully align with our view that the BoC will cut three more times this year, leaving the policy rate at 4% by year-end and USDCAD to drive up to 1.38 over the summer months. That said, we now expect the data to do the talking, beginning with May’s jobs report on Friday and then fresh inflation figures on the 25th.
If our expectations are met, this should see markets become attentive to the risk that the BoC cuts at the next two successive meetings, although we suspect the path of least resistance is to factor in closer to three more cuts over the course of this year relative to just the two currently discounted.
USDCAD converges to our medium-term target of 1.38 as markets factor in more easing from the BoC, but expectations still fall short of our year-end forecast for the policy rate of 4%
Author:
Simon Harvey, Head of FX Analysis