Bank of Canada Governor Tiff Macklem listens during a news conference following an interest rate announcement on Oct. 25, 2023, in Ottawa.Adrian Wyld/The Canadian Press
The Bank of Canada is expected to remain on pause for its first interest rate decision of the year, but analysts will be watching for hints about the timing of future rate cuts as the economy stagnates.
Financial markets and Bay Street economists see the central bank holding its policy interest rate at 5 per cent on Wednesday, in what would be its fourth stand-pat decision since July. It will also publish a new set of projections for inflation and economic growth.
Governor Tiff Macklem and his team are entering 2024 in a kind of limbo. High borrowing costs have brought economic growth in Canada to a standstill, unemployment is on the rise, and businesses and consumers are feeling gloomy, according to central bank surveys published last week. Yet so far, the economy has avoided an outright recession, which many economists were predicting this time last year.
Meanwhile, the annual rate of Consumer Price Index inflation has slowed considerably since a mid-2022 peak of 8.1 per cent.
However, it ticked up to 3.4 per cent in December from 3.1 per cent the month before, and measures of core inflation, which strip out the most volatile components of the CPI to capture underlying price pressures, appear to be stuck in the 3.5-per-cent to 4-per-cent range. Average hourly wages, which the bank watches closely, continue to rise quickly across the country.
“In terms of the actual setting of monetary policy, economic developments have been soft enough to reinforce that further interest rate hikes won’t be needed, but inflation (and wage growth) have also been too sticky to push the BoC to consider starting an easing cycle yet,” Royal Bank of Canada economists Nathan Janzen and Claire Fan wrote in a note to clients.
Interest rate swap markets, which capture market expectations about monetary policy, put the odds of the first rate cut happening in April at around 60 per cent, according to Refinitiv data. Many Bay Street analysts think it will be closer to the middle of the year, at the rate decision in June or July.
Mr. Macklem said last month that he needed to be convinced that inflation was on a “sustained downward track” before cutting rates. He said inflation should be “getting close to” 2 per cent by the end of 2024, and that the bank could start cutting rates before inflation gets all the way back to target, given that monetary policy changes work with a lag.
With markets pricing a high probability of a hold on Wednesday, the big questions are around the bank’s communication: How will Mr. Macklem and senior deputy governor Carolyn Rogers talk about inflation at the press conference after the rate announcement? Will they close the rhetorical door on further rate hikes, and open it to possible rate cuts in the coming quarters?
To date, central bank officials have maintained they could raise interest rates further if inflation doesn’t co-operate. But analysts and bond traders have largely dismissed the possibility. And the meeting minutes from the bank’s December rate decision suggest that most members of the bank’s governing council now believe that borrowing costs are high enough to bring inflation back to target over time.
If Mr. Macklem and Ms. Rogers focus on the stickiness of core inflation, it could be interpreted as a hawkish signal and lead traders to dial back bets on an April cut.
By contrast, if they play up the sluggish economy or the fact that inflation excluding shelter costs is now back within the bank’s 1-per-cent to 3-per-cent control range, it would be read as dovish. Shelter inflation is being heavily influenced by a jump in year-over-year mortgage interest costs, which are tied to the bank’s past interest rate hikes.
“The narrative will determine the data and not the other way around,” Canadian Imperial Bank of Commerce deputy chief economist Benjamin Tal wrote in a note to clients. “Therefore, the tone of Governor Macklem’s press conference will become increasingly more important than any new data releases because, at the end of the day, the Bank can always find an inflation number to fit its narrative.”
Analysts are also watching for a possible change in language around the Bank of Canada’s Quantitative Tightening (QT) program.
Since 2022, the bank has been shrinking the size of its balance sheet, which ballooned during the first 1½ years of the COVID-19 pandemic as it bought hundreds of billions of dollars’ worth of federal government bonds to suppress interest rates.
It has been letting these bonds mature without replacing them, leading its holdings to shrink from a peak of $430-billion to around $270-billion. This process is pulling liquidity out of the financial system, as the money created to buy the bonds in the first place – essentially reserves at the central bank called “settlement balances” – is retired.
Bank officials have said they expect to end QT in late 2024 or early 2025. However, analysts have started questioning whether the bank may need to halt the process before then, after recent signs of strain in money markets. Earlier this month, the bank had to pump money temporarily into the financial system on an overnight basis to try to keep market-based interest rates trading near its target.
Previous experience with QT in the United States shows that financial markets can start to misfire when the central bank tries to reduce its bond holdings and withdraw liquidity from the system. In the past, that led the U.S. Federal Reserve to stop QT early.
“Tapering or ending QT isn’t an easy decision to take. It would mean that the Bank of Canada’s purchases of Government of Canada bonds were not temporary after all, opening the institution up to criticism that it had financed the federal government’s massive COVID deficits,” Royce Mendes, head of macro strategy at Desjardins, said in a note to clients.
However, if the markets department at the central bank “determines that restraining QT is necessary, they won’t hesitate to act,” he said.