The Bank of Canada doesn’t want to be behind the curve

As we expected, the Bank of Canada slashed its policy interest rate by 50 basis points from 4.25% to 3.75% this morning—the largest cut since the early stages of the pandemic and a rare ‘oversized’ move outside a recession period.

The jumbo cut comes because inflation has already fallen to target and such restrictive policy rates are no longer needed. Last month’s CPI report sealed the 50 basis point cut in our view. Headline inflation broke through the 2% target to land at only 1.6%. And now the Bank expects inflation to be lower than it was forecasting in July (see below).

Our take: The right call, and a key moment in the battle against inflation. Late out of the gate when inflation took off, the Bank of Canada doesn’t want to be behind the curve as inflation normalizes. It takes 18 to 24 months for the impacts of policy rate changes to fully kick in, and speeding back to its neutral rate (estimated by the Bank to be 2.25-3.25%) will help prevent the economy from cooling too much. Even with this latest cut, policy will remain restrictive—more people are renewing loans at higher rates than before the rate hikes started. And if inflation flares up again, the Bank can simply hold longer at the current policy rate.

Excess supply to keep inflation at bay

Underpinning the weaker inflation trend is an economy running with ‘excess supply’, or below its potential. Canada’s economic growth has been tepid and has failed to keep up with the population. Without population growth, it’s likely that Canada would have already slipped into a technical recession. The Bank of Canada can move faster than the U.S. Federal Reserve due to a much weaker economic backdrop.

Some quotes:

“Excess supply is expected to remain at around 1% through the first half of 2025, with GDP forecast to expand at about the same pace as potential output. Starting in the second half of 2025, excess supply is gradually absorbed.” (October Monetary Policy Report)

“But with inflation back to 2%, we want to see growth strengthen. Today’s interest rate decision should contribute to a pickup in demand.” (Press Conference Opening Statement)

In its Monetary Policy Report, the Bank’s GDP  forecast is unchanged from July: real GDP growth of 1.2% and 2.1% in 2024 and 2025, respectively.

The bigger news is inflation. The Bank’s Inflation forecast has been revised lower, with the Bank now saying it “expects inflation to remain close to the target over the projection horizon, with the upward and downward pressures on inflation roughly balancing out.” The inflation rate is expected to average 2.5% in 2024 and 2.2% in 2025, down from its July forecast of 2.6% and 2.4%, respectively.

Is there a risk that inflation could re-ignite? Of course. An escalation of the conflict in the Middle East could raise oil prices. New tariffs could raise the price level. Canada’s combination of sticky wage growth and falling productivity can add to inflation. And lower borrowing costs could stoke demand in the housing market and add to already elevated household debt.

But the Bank must balance both the upside and downside risks. The dominant risk in our view is that the economy slows more than necessary to keep inflation near the 2% target. Increasingly, the Bank feels compelled to guard against that downside risk.

How did we get here?

It started in the spring, when the Bank of Canada adopted a more dovish tone. A brief and overly simplified timeline:

• April - Getting more confident, but waiting to see more progress on inflation  
• June - Inflation cooperates, the Bank cuts by 25 basis points
• July-September - Economy slowing, the Bank warns of downside risks and cuts twice by 25 basis points; in the U.S., the Federal Reserve cuts by 50 basis points in September 
• October - Inflation falls below 2% target last month, the Bank cuts 50 basis points (today)

What’s next?

The Bank of Canada has become more concerned about downside risks and more confident that it can lower rates without reigniting inflation. With inflation pressures easing, we believe the Bank will keep the rate cutting streak alive. The pace will depend on the upcoming data, but our current call is for a 25-basis point cut in December and three more early next year—bringing the policy rate to 2.75% by mid 2025.

Implications

Lower, but still higher than before. While on the descent, the policy rate will remain higher than it was before the rate hikes. If we’re right, about 2.5 percentage points higher.

More relief for variable-rate borrowers. Variable-rate loan rates will continue to decline, alongside the policy rate. But fixed rates, say 3 to 5 years, have already come down as the bond markets have priced in future rate cuts and far less additional movement can be expected there.

Confidence will improve, but the consumer needs time. Consumers have pulled back in response to a prolonged period of high inflation and rate hikes. Per capita spending has declined in Alberta and across Canada. Lower rates and the confidence that the inflation problem is being wrestled to the ground will result in a stronger pace of spending in 2025. But with a wave of mortgage renewals at higher rates in the next two years, many consumers will remain cautious.

Lower rates will attract new home buyers, but demographics will continue to play the dominant role. Alberta has bucked the national slowing trend in housing, in large part driven by inflows of interprovincial migrants. Edmonton has caught Calgary’s real estate fever, with sales and prices in that market picking up. We see some prospective buyers moving off the sidelines with these lower rates.

Challenges remain after the cuts. Monetary policy is a blunt instrument—it cannot solve all of Canada’s economic problems. Improving Canada’s productivity performance, as we’ve discussed in detail, is near the top of the list.

Answer to the previous trivia question: April 27, 1995 was the last time the Bank of Canada’s policy rate was over 8%.

Today’s trivia question: When did Mastercard become a publicly-traded company?