Sitting on the fence can cause uncomfortable splinters over time
The Bank of Canada today decided to hold rates at 0.25% despite acknowledging that economic slack, the precondition for raising rates, has now been absorbed. While sell-side analysts favoured this outcome by a split of 16-11, financial markets largely disagreed that this was the likeliest option. The resulting impact on financial markets after the initial decision was telling; the loonie dropped 70 pips to trade back above the 1.26 level on USDCAD, while bond yields dropped across the whole curve led by front-end rates. This occurred despite the Bank effectively teeing up lift-off at March’s meeting.
The decision, in our view, is a policy misstep from the Governing Council and is one that could prove costly later down the line. By effectively loosening financial conditions at today’s meeting, the BoC risks emboldening near-term inflation expectations and flaming the fire underneath the housing market.
This could result in lift-off taking the shape of a 50bps hike at March’s meeting should inflation expectations continue to rise and labour market metrics remain resilient to Omicron impacts in Q1. In analogous terms, should the data continue to print in a similarly robust fashion to Q4, the Bank has effectively swapped out a soft landing for the Canadian economy in favour of cutting the strings and reaching for the emergency parachute later on. With a 25bps hike unlikely to have caused too much damage to the economic recovery even at a time of activity restrictions in Ontario and Quebec, the Bank now runs the risk of having to put the genie back in the bottle with regards to inflation expectations at a later date. With real rates in negative territory, core inflation at a 30-year high, and financial markets giving the BoC a free pass, the question is why didn’t they take it? Governor Macklem will have a lot of explaining to do in what is set to be his hardest press conference to date.
We don’t want monetary policy to be “another source of uncertainty”
In response to our initial view that today’s decision to hold rates at 0.25% was a policy misstep, Governor Macklem and Senior Deputy Governor Rogers outlined that the Bank wanted to take a more cautious and staged approach to tightening policy, especially amidst the uncertainty of Omicron, such that monetary policy wasn’t another source of uncertainty. While this is commendable and solidifies the Bank’s position as sitting behind the curve when it comes to tackling inflation, it still doesn’t square with the Bank’s outlook on inflation nor their level of discomfort towards price growth. Questions then centred on the impact today’s decision has had on the Bank’s credibility, which draws parallels with Mark Carney’s “unreliable boyfriend” years at the Bank of England and his successor Andrew Bailey’s decision to hold rates at November’s meeting despite heavily indicating that rates would rise, along with their confidence that long-term inflation expectations would remain anchored.
The latter point was pertinent, as Governor Macklem pointed to the lack of movement in the longer-term inflation expectations and uncertainty caused by Omicron to relay the message to hold rates today.
Should longer-term inflation expectations start to move in tandem with near-term expectations, which jumped over a percentage point to above 4% over the two-year horizon in the latest consumer expectations survey, the Bank would have to start to become more reactionary to inflation conditions. This could prove instrumental in determining the Bank’s projected rate path and expectations of terminal rates.
Although today’s BoC decision didn’t fall in line with our base case and therefore didn’t see USDCAD drop towards the low 1.25 level or even return to last week’s lows in the mid-1.24’s, our hawkish view on Canadian rates remains. We now think that risks tilt heavily towards the BoC hiking rates by 50bps at March’s meeting.
Should the wage-price spiral start to manifest more visibly in Canadian data and domestic inflation pressures become more broad-based such that disinflation towards the Bank’s 3% target looks less likely, the risks of rates sitting at 1.5% by the end of H1 are non-negligible. For the remainder of the day, volatility in USDCAD is unlikely to moderate despite the BoC shock already taking place as markets quickly turn their attention towards the imminent Fed decision. The loonie has now retraced half of its post-BoC decline to trade a quarter of a percentage point higher against the dollar, while the potential for CAD to close at session highs is sizeable as risks are tilted to the Fed underdelivering on market expectations.
The loonie recovers half of its losses following the BoC’s decision to hold rates as traders now look to the Federal Reserve
Author: Simon Harvey, Head of FX Analysis