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The Bank of Canada left its policy rate unchanged at 5% today, which was no surprise given how hawkish policymakers have sounded heading into today’s meeting despite weaker data year-to-date.
Nevertheless, there was a risk that the Bank would take a more proactive stance seeing as inflation conditions have cooled rapidly at the start of the year, against seasonal norms, while the labour market has also significantly loosened. This risk was priced at around 20% by markets prior to the decision and was reflected in the Bank’s characterisation of the output gap and labour market conditions, alongside its inflation outlook, all of which suggest the BoC should have cut rates today. However, having conducted multiple policy errors since the start of the pandemic on the back of failed forecasts, the Bank took a more conservative stance, stressing the need to see more of the same in the realised data before easing policy. While holding rates against a body of evidence suggesting otherwise has hawkish implications, we think the BoC came across as notably dovish at today’s meeting. This was most visible in the Bank’s easing criterion. Policymakers no longer need to see a further easing in core inflation before cutting rates, as they said in January, but instead that “downward momentum is sustained”. Moreover, by holding rates at today’s meeting, the BoC will keep financial conditions tighter for longer.
Based on our view that the Canadian economy is much weaker than the headline GDP data suggest, as evidenced by benign inflation conditions and firms’ hiring decisions, we suspect this keeps the bar low for the BoC to ease in June and successively thereafter.
Bank staff expect less inflation, with the target achieved in 2025
Today’s policy announcement took place against the backdrop of an Monetary Policy Report that skewed notably more dovish than the prior January edition. Staff now expect inflation at 2.8% in Q1, 0.4pp lower than January and in line with our expectations for a reduction of roughly half a percent. Notably, Q2 inflation is also expected to rise only marginally, to 2.9%, with CPI growth set to land at just 2.2% by Q4, meaning that Bank staff now expect inflation to remain within their tolerance band for the rest of the year. Bank staff ultimately expect inflation to return back to its 2% target by 2025, just as the economy converges to its potential growth rate. Put another way, the Bank is now forecasting a soft landing outcome. Driving the Bank staff’s more dovish inflation outlook, despite stronger growth expectations, was its updated view on potential growth. The estimate of potential output increased from 2.1% to 2.5% in 2024, meaning that while GDP growth was revised up from 0.8% to 1.5% this year, this doesn’t threaten the Bank’s view on inflation. In fact, the Bank estimated that the output gap to lie between -0.5% and -1.5% in the first quarter, roughly unchanged compared with their Q4 estimate.
We are a little more sceptical on the outlook for the Canadian economy as the micro-signals from the economic data suggest the demand outlook is significantly more benign than headline GDP growth suggests.
As a result, we suspect inflation could converge back to target as early as this year, warranting the Bank to quickly lower nominal interest rates to its estimate of neutral, which is now estimated at 2.75% with an upper bound of 3.25%. Our view is based upon the weak pace of core inflation year-to-date, which if replicated in March, would lead the Bank’s preferred 3-month annualised rate to fall from 3.5% at the turn of the year to just 1.2% by the end of Q1. Moreover, inflation ex-shelter also scans as weak, a point tacitly admitted by Governor Macklem in his press conference. With the policy rate currently at 5%, the BoC would need to cut a minimum of 175bps to bring policy back to a neutral setting if our suspicions are proven. Although we doubt the Bank will need to cut rates back to neutral this year unless a recession occurs, under our base case it would need to cut rates at every meeting from June this year, bringing the policy rate down 125bps to 3.75%. The biggest risk to this view stems not from the Canadian data, but external factors. Namely, upside in oil prices and a more hawkish Federal Reserve pose the largest risks, with the latter proving particularly pertinent given March’s US inflation report today.
This single-handedly led markets to price less BoC easing for this year, with expectations for Canadian rates following those for the US, in spite of the BoC’s own dovish communications. As such, having started the day flirting with the idea of three BoC rate cuts this year, traders were left looking for just two and a half post-meeting.
Core inflation pressures have disappeared in Canada, even if the BoC are reluctant to say it this early on
Upcoming data should see BoC diverge from the Fed, prompting further USDCAD upside
While the Bank of Canada pointed towards shelter inflation and only nascent signs that inflation pressures are easing to maintain a relatively conservative tone at today’s meeting, we suspect this message will be undermined by March’s economic data. Not only should headline and core inflation pressures cool further, but the breadth of inflation should also continue to narrow and wage pressures cool in line with businesses’ expectations and reports of easier hiring conditions. All told, this should increase the markets’ conviction that the BoC will need to cut rates at successive meetings, which set against a more inflationary US backdrop, should lead USDCAD swap rates to widen further.
In isolation, this supports our view that USDCAD should climb to the range of 1.38-1.40 in Q2, although given Canada’s reduced recession risk and the limitations to which BoC expectations diverge from the Fed’s, we no longer expect the currency to break above 1.40.
The BoC could cut twice before the Fed even begins to ease, suggesting there is more upside on USDCAD swap rates, which already argue in favour of further USDCAD upside
Authors:
Simon Harvey, Head of FX Analysis
Nick Rees, FX Market Analyst