Governor of the Bank of Canada Tiff Macklem speaks following the Bank of Canada’s release of the 2024 Financial Stability Report in Ottawa on May 9.Justin Tang/The Canadian Press
Craig Alexander is a contributing columnist for The Globe and Mail. He has served as chief economist at Deloitte Canada, the Conference Board of Canada and Toronto-Dominion Bank.
The Bank of Canada’s decision to lower interest rates by a quarter of a percentage point on Wednesday is welcome news. It demonstrates that the central bank has confidence that the battle against inflation is nearing completion, and this sets the stage for a series of rate cuts that constitute a rebalancing of monetary policy in the months ahead. Indeed, Bank of Canada governor Tiff Macklem stated, “If inflation continues to ease … it is reasonable to expect further cuts to our policy interest rate.”
Before popping the champagne corks, however, there are two important questions that need to be considered. First, how far will borrowing costs fall? Second, how stimulative to the economy and real estate markets will the reduction in interest rates prove to be? I believe the decline in rates and the economic stimulus will be limited. Indeed, Mr. Macklem also said, “But we are taking our interest-rate decisions one meeting at a time.”
The scope to lower interest rates will be determined by the economy’s performance and the evolution of price pressures. The Canadian economy is currently delivering a sub-par performance, but it is not experiencing significant weakness, such as an economic contraction. Similarly, the labour market is not particularly weak. Yes, the unemployment rate has increased by a percentage point over the past year, but the level at 6.1 per cent in April was close to what economists have traditionally viewed as full employment.
Some slack in the economy has developed because of the sub-par pace of economic growth in 2023 and the rapid pace of population growth that temporarily lifted the non-inflationary rate of expansion in the economy to around 2.5 per cent in 2024. But, given the government’s efforts to reduce the inflow of non-permanent immigrants, the Bank of Canada estimates that the sustainable rate of growth in the economy will fall to 1.7 per cent in 2025.
The implication is that the economy warrants lower interest rates, but the Bank of Canada will be cautious about stoking a strong acceleration in economic activity.
On the pricing front, there are several issues. The Bank of Canada is clearly nervous about lower mortgage rates causing house prices to rise sharply as a source of inflation. So those hoping rate cuts will reignite real estate markets are likely to be disappointed because the monetary authority will stop lowering rates if that starts to happen.
The Bank of Canada also must be mindful that inflation risks remain elevated because of structural changes in the global economy. Globalization is no longer having the disinflationary impact of the past. Firms are shifting their supply chains to build greater resilience, but this is adding to costs that will be passed along to consumers. Geopolitical tensions can also add to price pressures, as protectionist trade policies and responses to unfair trade practices add to the costs for goods and services. Businesses also appear to have regained some pricing power in recent years, such as using dynamic pricing models that allow firms to maximize profits through constantly adjusting prices to reflect changes in demand and in response to the pricing of their competitors.
Foreign exchange rates also matter. Although the Bank of Canada can run an independent monetary policy, if Canada lowers rates to well below those in the United States, the Canadian dollar weakens. This can push inflation in Canada higher because a weaker loonie raises the cost of imports.
So, what is the U.S. central bank likely to do? Inflation is proving stubborn in the United States. Speeches by Federal Reserve officials have suggested that U.S. interest rates will remain at current levels for longer. Accordingly, financial markets have only priced in one quarter-percentage-point interest-rate cut this year, with the distinct possibility that the Federal Reserve remains on hold for all of 2024.
The Bank of Canada’s overnight rate already stands roughly half a percentage point below the U.S. federal funds rate and financial markets have been expecting the Bank of Canada to cut rates before the Federal Reserve, which is why the Canadian dollar has been trading around 73 U.S. cents. Before the latest Bank of Canada rate decision, markets had priced in a half-percentage-point reduction in the overnight rate this year. If Canadian interest rates fall by more than that, the Canadian dollar will fall. This doesn’t prevent the Bank of Canada from lowering interest rates further, but it does affect the timing and the degree of monetary-policy easing.
All of this argues that the scope of reduction in interest rates will be limited, which, combined with the 12- to 18-month lag between changes in rates and their full impact on the economy, suggests the degree of economic stimulus in the near term will be small.
Make no mistake, the Bank of Canada’s decision to cut interest rates is unambiguously positive. The shift in monetary policy from being on hold to a stand of lowering borrowing costs over time is meaningful and will provide some welcome relief to households and businesses. At the same time, Canadians need to be prepared for a very gradual reduction in interest rates that will likely be accompanied by many pauses along the way.