Bank of Canada Governor Tiff Macklem takes part in a news conference after announcing an interest rate decision in Ottawa, on March 6.Blair Gable/Reuters
Jeremy Kronick is associate vice-president and director of the Centre on Financial and Monetary Policy at the C.D. Howe Institute, where Steve Ambler, a professor of economics at Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy.
The Bank of Canada finally pulled the trigger on Wednesday and reduced its policy rate by 25 basis points. Forecasters were split between a June or July cut, but over all, the data were just too strong in favour of a cut – or too weak, as it were, considering the latest GDP numbers.
This marks the beginning of a cycle of easing policy rates. The question for most commentators, investors and consumers is now: how far and how fast?
The bank cut its policy rate from 5 per cent to 4.75 per cent. Despite the cut, a strong case can be made that monetary policy is more restrictive now than it was at the Bank of Canada’s announcement on April 10. This augurs well for further declines in inflation and further rate cuts. Over time, our still-above-target inflation – both the headline number and the bank’s preferred core inflation measures, CPI-Trim and CPI-Median, which strip away volatile components of the price index – should continue to fall back toward the 2-per-cent target, giving the bank more room to cut.
We say the bank’s monetary policy is more restrictive because what matters is not the nominal policy rate, 4.75 per cent, but the real policy rate – the nominal policy rate minus inflation.
In April, when the nominal policy rate was 5 per cent, the real policy rate, after subtracting headline inflation, was 2.2 per cent, while it was 1.8 per cent for CPI-Trim and 1.9 per cent for CPI-Median. Today, with the cutting of the policy rate to 4.75 per cent, while the real policy rate for headline inflation is a more stimulative 2.05 per cent, it is more restrictive for CPI-Trim and CPI-Median at 1.85 per cent and 2.15 per cent respectively.
A more restrictive monetary policy in real terms gives the bank added space to continue cutting. Even with headline and core inflation measures now inside the upper bound of the bank’s target band (1 per cent to 3 per cent) and actually below the target (at annualized rates) over the past three months, real rates will likely justify further cuts.
The timing and depth of those cuts is now the question.
To answer it, we need to estimate the neutral rate that the bank aspires to reach in the long run. While definitions differ, for our purposes, it is the bank’s policy rate compatible with inflation steady at its 2-per-cent target and an economy at full employment. This rate is not directly observable. However, the Bank of Canada regularly updates its best estimate.
Most recently, the bank stated that this rate lies within a range of 2.25 per cent to 3.25 per cent – 25 basis points higher than its April, 2023, estimate. Taking the midpoint of the range (2.75 per cent) as the base case, the bank’s current policy rate is two full percentage points higher than the neutral rate, signalling that up to eight more rate cuts of 25 basis points are in the pipeline.
With the exception of the recent rate hikes, we have not seen a policy rate as high as 2.75 per cent since October, 2008. The policy rate is very unlikely to go lower than this unless the bank needs to fight a deflationary recession, so Canadians will likely have to get used to an era of higher interest rates.
The speed of the cuts is also in question. Rate cuts will be tempered by domestic factors, e.g. fiscal stimulus in the form of government spending, and population growth, but also by what is happening in the United States. There, inflation seems to be stuck above where the Federal Reserve wants it to be, and in response, it is talking tough, leaving markets uncertain as to when the easing cycle might begin. A certain amount of divergence between the Bank of Canada’s and the Fed’s policy rates is okay, especially as the Canadian economy becomes more services-oriented where domestic factors matter more for pricing. However, there is a limit, as this divergence puts downward pressure on the Canadian dollar, which, among other things, is inflationary because it boosts the price of imports. The robustness of the U.S. economy will be important to watch.
Whether the cuts come sooner or later will depend on many factors, not least of which is what happens south of the border. But the rate cut was justified this time, and there are more to come.