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Across nearly all measures, inflation pressures in Canada cooled considerably in February. Headline inflation undershot consensus expectations by 0.3pp to print at just 0.3% month-on-month, while on a seasonally adjusted basis, it grew a meagre 0.1%. This led the annual measure of headline inflation to fall 0.1pp to just 2.8%, defying expectations for a similar increase.
The bulk of headline inflation also stemmed from a handful of components; a 10.96% increase in the price of travel tours, a 0.8% increase in gasoline prices, and another month of strong housing inflation. The BoC’s preferred measures of core inflation strip these effects out and show further disinflation progress, with both CPI-trim and CPI-median measures falling 0.2pp to 3.2% and 3.1% YoY respectively. These measures are likely to continue to fall to below 3% as well, seeing as their underlying run rate has cooled dramatically to an average pace of 2.23% on a 3-month annualised basis.
On the whole, February’s inflation report is highly constructive for the Bank, but unfortunately for them it lands just two weeks after they moved the goalposts for an interest rate cut, stressing the level and the breadth of inflation as opposed to the rate of change to guide markets towards June as the likeliest time to begin easing.
But even on these measures we’re seeing continued progress (more on this later). Thus, with inflation measures trending in the right direction, the economy continuing to produce below-potential growth, and the labour market back into better balance, the Bank runs the risk of maintaining an overly restrictive policy for too long should it fulfil its guidance and delay any easing until June. If this is the case, such a stance could see policymakers forced to play catch-up with the economy in the second half of this year and cut rates by more than 25bps in a singular meeting.
While critics will argue that policymakers will need a third confirmatory inflation report before cutting rates, we think the Governing Council could renege on its March guidance and commence its easing cycle in April, should March’s labour force survey and the Bank’s Q1 surveys return favourable results.
If this is correct, this would be a watershed moment for the Bank seeing as it has strived to improve its communications under Macklem’s tenure, but ultimately we think a reversal on its forward guidance is less damaging for the central bank, rather than inducing unnecessary economic pain because it can’t look beyond its priors.
Near-term measures of Canadian inflation paint a compelling argument for the BoC to ease sooner rather than later
Diving further into the inflation measures, disinflation progress was clear across all measures bar inflation breadth, which ticked up from 46% to 55% using level 4 product groups rising by more than 3%, but even here this was solely driven by an increase in the large and relatively volatile operation of passenger vehicles component. Outside of this metric, the evidence supporting a looser monetary stance was clear. The Bank’s core inflation measures showed continued progress, with the 3-month average annualised rate dropping to levels last seen in February 2021 when the economy was effectively closed, while the measure is likely to drop further in March once December’s bumper increase falls out of the calculation. For reference, should the year-to-date monthly increase in core inflation be sustained in March, the average pace of sequential core inflation will almost halve, from 2.23% to 1.16%. Weakness in underlying inflation was also visible in core CPI ex shelter, which dropped to 0.7% YoY in February. Admittedly, the less restrictive CPI ex-rent and mortgage costs stabilised at 1.4%, though still declined slightly on an unrounded basis and remains below the BoC’s 2% inflation target in any case. Moreover, while the BoC could have been inclined to discount these measures in line with the March meeting commentary, this is somewhat harder to do when the CPIX measure of price growth also collapsed in this latest round of data. At 2.1% YoY, CPIX is now essentially back to target. When considered on a 3-month annualised seasonally adjusted basis, inflation by this measure has disappeared completely, with the reading flatlining at 0.0% in February.
While we think the Bank of Canada should cut rates in April, whether it does or not is still an open question. After all, the Bank has notoriously been too slow to react to turning points in the economy, producing two policy mistakes throughout its tightening cycle alone.
For the Canadian dollar, whether the Bank cuts in April or delays until June effectively generates two scenarios; one in which we believe USDCAD could trend up to 1.38 in the short-term and another where the pair could breach 1.40 in the medium-term. By taking a more pragmatic approach and cutting in April, we suspect FX markets will respond unfavourably to the earlier sequencing of rate cuts in Canada, but this should be temporary and offset over the medium term by the positive growth impact and likely higher terminal rate. On the contrary, while a delay until June will help shelter the loonie against a more hawkish Federal Reserve in the short-term, we think such actions merely amplifies the economic pain inflicted on the Canadian economy and the risk the BoC will need to cut rates faster and to a lower terminal level than the Fed over the medium-term.
Throw in the potential for a recession or prolonged stagnation in Canada against a backdrop of stronger US growth and higher Treasury yields, a world in which USDCAD trades back through 1.40 isn’t unimaginable should the BoC hold next month.
Authors:
Simon Harvey, Head of FX Analysis
Nick Rees, FX Market Analyst