Governor of the Bank of Canada Tiff Macklem participates in a news conference on the Bank of Canada’s release of the 2024 Financial Stability Report, in Ottawa, on May 9.Justin Tang/The Canadian Press
In January, 2022, the conditions were in place to start hiking interest rates.
The annual pace of inflation had reached 4.8 per cent the previous month, more than twice the Bank of Canada’s target. Having played down the risk of inflation through 2021, central bankers were beginning to sweat. It was long past time to start tightening monetary policy.
Still, when the Jan. 26 rate decision arrived, the Bank of Canada punted. Instead of lifting interest rates off the ground, where they’d been since the early months of the pandemic, Governor Tiff Macklem used the rate decision to tie up loose ends and signal a rate hike would be coming at the next meeting in five weeks’ time.
This history could be instructive as the Bank of Canada approaches another turning point.
Next Wednesday, June 5, Mr. Macklem and his team have their first real opportunity since rates started to rise in 2022 to begin easing monetary policy.
Inflation has been back inside the bank’s target range for four months, while high interest rates continue to squeeze households and businesses. The latest GDP data, published Friday, came in weaker than expected and showed the economy decelerating through the first quarter.
All told, recent data suggest it’s time for the central bank to reverse course and start cutting rates before it drives the economy into an unnecessary recession and blows past its 2-per-cent inflation target on the way down.
But there are arguments for remaining on hold until July, which could sway a group of wary central bankers, scarred by the experience of losing control of inflation that got as high as 8.1 per cent in mid-2022.
The Canadian real estate market is spring-loaded, and home prices could take off as interest rates start to fall. That’s something Mr. Macklem and the bank’s five deputy governors might want to delay until they’re well clear of the spring homebuying season.
Likewise, the Bank of Canada can’t get too far ahead of the U.S. Federal Reserve, which is not expected to start cutting interest rates until September at the earliest, without putting downward pressure on the Canadian exchange rate.
Then there are the intangibles. Central bankers are a conservative bunch who typically prefer to move methodically and signpost changes ahead of time, as they did in early 2022. Given the choice between waiting too long and squashing the economy more than needed, and cutting too early and risking a rebound in inflation, the BoC’s governing council may be inclined to pick the former – especially after their credibility has been tarnished by several years of runaway price increases.
“There’s no right answer as to when you should cut. There’s a judgment made by central bankers based on a swath of data, and unless you’re in the room you don’t know specifically what will tip the scales toward one decision or another,” Frances Donald, chief economist of Manulife Financial, said in an interview.
“In normal times, the Bank of Canada would probably have the all-clear to start cutting now and to cut pretty significantly. But they will be haunted that a mistake of cutting too early or too fast would be extremely costly for the Canadian public, which has already suffered through a sizable inflation shock,” she said.
Adding it all up, financial markets are leaning toward a quarter-point rate cut next week, with interest-rate-swap traders putting the odds at around 80 per cent following Friday’s GDP data.
That would be a historic turning point after the biggest inflation shock since the 1980s and one of the most aggressive monetary policy-tightening campaigns on record, which saw the Bank of Canada raise rates 10 times between March, 2022, and July, 2023.
Based on the data alone, it’s becoming hard to make the case that the bank’s policy rate should still be at 5 per cent, a two-decade high reached last summer. Simply put, inflation looks fairly good, while the economy looks fairly bad.
Annual Consumer Price Index (CPI) inflation surged in 2021 and 2022 on the back of supply chain problems, commodity price shocks and strong consumer demand, juiced by low interest rates and generous government support during the pandemic.
Since peaking in June, 2022, price increases have mellowed as the global drivers of inflation waned and high interest rates stunted domestic demand. By the start of this year, headline CPI inflation was back inside the Bank of Canada’s target range of 1 per cent to 3 per cent, hitting 2.7 per cent in April.
Core inflation measures are now running below 3 per cent. And while shelter inflation remains worryingly high, if you strip out mortgage interest costs, which are in the Bank of Canada’s control, inflation is already below the 2-per-cent target.
Meanwhile, the Canadian economy is stumbling. Unemployment is up a full percentage point over the past year and business insolvencies have spiked. The economy as a whole has been operating below potential for several quarters.
“Those are really the three major things that the Bank of Canada looks at: inflation, the labour market and overall growth. And they’re all pointing in the same direction. So I like the call that they start the proceedings next week,” Doug Porter, chief economist at Bank of Montreal, said in an interview.
However, it’s not a sure thing, Mr. Porter said. The economy has not fallen into an outright recession and indicators of financial stress, such as mortgage delinquencies, are not flashing red. That gives the bank some wiggle room if it wants to play for time to see two more inflation reports.
Mr. Macklem and his team also have to think about the U.S. Federal Reserve, which is dealing with a stronger economy and more stubborn inflation.
“It’s a tough decision and it’s a close call, and of course, what’s made it a tougher call is the fact that the prospects of the U.S. cutting rates keeps getting pushed further and further into the distance,” Mr. Porter said. “If it was simply a domestic issue, I don’t think it would be that tough a call. I think the bank would be leaning pretty heavily to starting the process now.”
Ms. Donald of Manulife said concerns about BoC-Fed divergence might actually, counterintuitively, argue in favour of a rate cut next week. Waiting longer increases the risk of a recession, she said. And that would mean more cuts by the Bank of Canada down the road, and a larger gap between the two countries’ monetary policies.
The challenge for the Bank of Canada, whatever path it chooses, will be to manage expectations. One quarter-point rate cut won’t suddenly make housing affordable again, and people renewing their mortgages over the next year or two are still in for a major payment shock, regardless of whether the central bank moves next week or in the middle of the summer.
Mr. Macklem has said repeatedly in recent months that interest rates won’t fall as quickly as they rose, and that borrowing costs will likely settle at a higher level than Canadians were accustomed to in the decade between the 2008 financial crisis and the COVID-19 pandemic.
“I think there’s a good case that they may choose to go every other meeting, so you have 12 weeks which gives you two inflation reports and two jobs reports,” Beata Caranci, chief economist at Toronto-Dominion Bank, said in an interview.
“I still believe that the most we’ll get this year is 75 basis points. So their starting point doesn’t change the cumulative amount that I would expect.” (There are 100 basis points in a percentage point.)
A similar story is playing out around the world. Having raised interest rates roughly in tandem, most advanced economy central banks are preparing to pivot.
The Swiss National Bank and Sweden’s Riksbank have already begun easing, and the European Central Bank is expected to deliver its first rate cut on Thursday, the day after the Bank of Canada’s decision. Financial markets expect other advanced economy central banks to follow suit over the summer, with the exception of the Fed and the Bank of Japan.
High interest rates have hit some countries harder than others. But most have avoided major recessions, achieving a “soft landing” that few economists thought possible given the scale of the inflation problem and the barrage of interest-rate hikes.
“It’s too early to break out the champagne bottles. We’re not quite there yet, especially in the U.S.,” Mr. Porter said. “But it does seem like they have struck the right balance, weakening the economy just enough to bring down inflation without tipping it over the edge. And we were not sure they could do that.”