Bank of Canada Governor Tiff Macklem speaks in Montreal, on Feb. 6.Christinne Muschi/The Canadian Press
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.
Headline inflation in January moved back into the Bank of Canada’s 1- to 3-per-cent target range. Yet on Wednesday, the bank again held its target for the overnight rate at 5 per cent.
Why is the bank reluctant to cut? There are two main impediments: core inflation, and concerns over expectations. Both are fair reasons to keep rates where they are, but both measures are easing or should ease soon. An April rate cut may therefore be in the cards.
The bank’s mandate is to target 2-per-cent headline inflation. But headline inflation contains a number of volatile items, such as energy, and so to get a sense of underlying price pressures, many central banks have measures of core inflation that strip away these components. The bank’s preferred core measures are CPI-trim (excluding the most volatile items) and CPI-median (focusing on the price change at the 50th percentile).
Both core indicators have been sticky throughout this tightening campaign and remain well above their targets at 3.4 per cent and 3.3 per cent, respectively. It is reasonable that the bank would like more clarity that those underlying price pressures are easing.
Expected inflation might be trickier to deal with given previous inflation rebounds during this tightening cycle. If the bank were to cut rates and inflation reverses course again – perhaps as a result of a housing market that seems coiled and ready to go – expected inflation might increase. That in turn would lead to greater price increases by companies, and higher wage settlements for workers, feeding back into increased inflation.
But despite the bank’s valid concerns about both core inflation and inflation expectations, we see signs that easing is upon us, or should be soon.
Over the past three months, the Consumer Price Index has increased at an annualized rate of only 1.8 per cent, below the Bank of Canada’s target, and the seasonally adjusted CPI actually fell between December and January. Three-month numbers are still elevated for CPI-trim and CPI-median. However, an alternative measure of core inflation known as CPIX, which strips out eight of the most volatile components and excludes the effects of indirect taxes, was only 2.4 per cent in January, year-over-year, and just 1.6 per cent at an annualized rate over the past three months.
These declines in inflation mean the bank’s real policy rate (the nominal policy rate minus the inflation rate) has become more restrictive over this time. Since the overnight rate target reached its 5-per-cent peak in July of 2023, inflation has dropped 0.4 percentage points. So, in real terms, monetary policy has become 0.4 percentage points more restrictive, which should restrain demand further.
Although the GDP growth headline last week was a positive surprise, domestic demand was weak. Growth was almost entirely driven by an increase in exports, a nod to how strong the U.S. economy has been.
Whether the United States can continue to buoy the Canadian economy is unclear. In part, this is because the Federal Reserve may not be as close to cutting rates as the Bank of Canada. The Fed uses the Personal Consumption Expenditure price index as its primary measure of inflation – targeting 2 per cent, as we do here. That measure has been falling, hitting 2.4 per cent in January. However, the Fed has focused during this tightening cycle on what it calls supercore inflation – inflation from core services excluding housing – and this measure increased markedly in January.
Consequently, the Fed is still talking tough, probably even tougher than the Bank of Canada. If the U.S. economy begins to finally slow with rates remaining elevated, what’s left of our GDP growth might fade away. This will feed through into core inflation and expectations.
We understand the bank’s hesitancy to lower rates too soon. But, with the economy teetering, core inflation should continue to fall, and expectations that the bank will get inflation back to 2 per cent will firmly re-anchor. The next time we hear from the bank in April we may see the rate cut many have been waiting for.