The Bank of Canada continued its conditional pause, maintaining the policy interest rate at 4.5%, and said that quantitative tightening is still rolling out as planned to support restrictive policy.
The Bank maintained the same key risks to the inflation outlook as in January, noting that persistent upside services inflation and a severe global slowdown are the main upside and downside risks. The details were different, though, with the Bank now mentioning that an intensification in global banking stresses could tighten global credit conditions and feed through to a more severe global slowdown. Despite the risks stemming from global banking troubles, the Bank reiterated its hawkish bias, noting that it is “prepared to increase the policy rate further if needed,” which makes sense considering that economic activity has proven more resilient than expected in the first quarter.
In the press conference, however, Macklem downplayed the possibility for future hikes, and instead suggested that rates could simply be kept higher for longer, mirroring similar communications from the Federal Reserve.
Following the news, yields reversed some of the post-US CPI losses, with traders paring bets for BoC rate cuts over the next few meetings, in direct response to Macklem’s comments. On the other hand, the loonie held firm against the greenback, having bounced around through the course of the day, first on US inflation data and then on the BoC rate decision.
Non-credible inflation forecasts
The Bank’s updated set of forecasts are difficult to square with one another. Officials noted that economic growth was stronger than expected, both in Canada and globally. After nearly tripling their US growth forecast for 2023, from 0.5% to 1.3%, raising their Canadian growth forecast from 1.0% to 1.4% while reducing their estimate of 2023 potential output by 1%, factoring in $25bn more fiscal spending over three years, and reiterating that the labour market is still tight, the result should be an output gap that is 1.4pp more positive than last quarter. One would expect that the sizable impact on the output gap would clearly result in stronger inflation than previously forecast. This is the message delivered in the rate statement, which cautions that getting inflation “back to 2% could prove to be more difficult,” but completely contradicts the message from the updated inflation forecasts, which were left virtually unchanged and downgraded by a tenth to 2.5% by 23Q4. When pressed on this inconsistency during the press conference, Macklem was unable to muster a convincing explanation, arguing that downgrades to fourth quarter growth offset the upgrade to first quarter growth.
Follow-up questions pressed the Governor about the accumulating evidence that inflation will remain sticky—including strong wage growth, inflation expectations, corporate pricing power, and services inflation—but he dismissed these factors by pointing to the fall in headline inflation, which conveniently ignores that these developments were mostly driven by mechanical base effects. Three-month average rates are on target for headline inflation because of softer commodity prices, but core prices are still hovering around twice where they need to be.
Not much concern voiced about banking risks
While the latest interest rate decision did acknowledge the downside risks to inflation and growth stemming from global banking turmoil, Deputy Governor Rogers downplayed these risks during the press conference. Recognising that the immediate focus of regulators following the recent banking concerns had been financial instability, Rogers also noted that the relevant authorities in the US and Switzerland acted quickly to prevent any contagion.
She went on to say that the expected economic impact was a pullback in lending, which in turn weighs on growth, something that the bank had considered.
While the monetary policy report said a deeper credit crunch could drag the global economy into a sharp slowdown, Rogers finished on a note that conditions are now calming, which suggest that officials are not overly concerned with the financial troubles that emerged in the past month.
Macklem unsuccessfully tries to sidestep questions about fiscal policy and unions
It’s always a prickly challenge for the Bank of Canada when journalists ask about government spending or wage negotiations, as being forthright about their economic impacts can cause political drama. During today’s meeting, Macklem was placed in this tough spot again, faced with astute questions about whether the increase in fiscal spending and ongoing public sector wage negotiations could fuel inflation. One can only speculate as to what went through the Governor’s mind, but it was probably along the lines of, “Of course! But you know I can’t say that.” In a jumbled response, Macklem conceded that the latest budget isn’t helping the fight against inflation, and “could” make it more difficult to get inflation back on target. Responding to the question on wage negotiations, which noted that public sector unions are pushing for a 9% pay rise over three years, Macklem simply refused to answer the question and returned to his stump speech about inflation coming down.
The crux of the matter is that the Bank of Canada is still more concerned about upside risks to inflation, as Macklem made explicit during the presser. While the Governor discounted much of the latest evidence to maintain last quarter’s inflation projections, the reality is that price pressures and the factors which fuel them are stronger than the Bank is letting on. For now, assuming that the Bank’s view that global banking stresses are subsiding holds true, we think that the strong emphasis on “higher for longer” in the press conference should take greater precedence over the statement’s mention that rates could be raised, suggesting a continued pause for the June meeting at least.
Clearly, the Bank is going to try to stick to this view until contradictory evidence is so overwhelming that it is forced to change its policy.
Whether that change is a rate hike or a cut depends mostly on how the banking story develops. If it fades out, we would expect a probable resumption in the hiking cycle. But should the Bank’s downside risk of a credit tightening-driven global recession materialise, expect the mirror image of the start of the current hiking cycle: previous words will no longer matter, and a pivot to cuts could easily emerge.
Jay Zhao-Murray, FX Market Analyst
Nick Rees, FX Market Analyst