Bank of Canada policy update

The Bank of Canada cut its policy rate by 25 basis points as expected, but the focus of its commentary had less to do with its current assessment of the Canadian economy and much more on how to navigate an economy that potentially gets significantly knocked off course by U.S. tariffs.

The BoC had a good understanding (and confidence in) how the economy is currently travelling. With 200 bps of easing already in the pipeline, Canadian growth is low but slowly improving, the unemployment rate is near a peak, and inflation is now well within the BoC’s target range. We agree. Without any shocks, the central bank would likely continue to gradually ease towards, we think, 2% by year end, but in smaller magnitudes and at a slower pace than in 2024.

But, the BoC isn’t facing standard run-of-the-mill uncertainty in its outlook. Both the Monetary Policy Report and Governor Tiff Macklem’s communication took a very different tone this time around. If central banks use the idea that setting monetary policy in uncertain times is like walking around in a dark room and trying not to trip on furniture, the BoC could more appropriately be described as blindfolded with projectiles being thrown at it.

Indeed, the BoC is fighting two particular demons that make its base case forecasts and current assessment of the state of affairs far less useful than usual. Instead, the value of their communication is in the clues they drop about how they might navigate the shocks ahead. We think most signs continue to point to further declines in interest rates, the magnitude and speed of which will be determined by the details of a potential U.S.-Canada trade conflict.

1. The BoC is facing “more than unusual uncertainty.”

It mentions “uncertainty” 42 times in the report, and, even before launching into the MPR, the BoC states its economic outlook doesn’t include any specific U.S. tariff policies yet. Governor Macklem says that we are simply missing too many pieces of information to know exactly what a trade war means for Canada.

“There’s a lot of things we don’t know, when and for how long,” he says. “We don’t know what retaliatory measure… or fiscal measures will be taken in advance”.

As we highlighted in our A playbook for how to measure a tariff shock in Canada, those details can be very significant on the direction and size of the impact in Canada.

However, the forecasts recognize that tariff threats are already impacting financial markets and business decisions. We’ve also been highlighting that tariff threats creates a negative “uncertainty” shock that weighs on growth. Downward revisions to the BoC’s forecasts for growth in 2025 and 2026 to 1.8% reflects some of this.

Moreover, Governor Macklem noted tariff threats alone “weighed on our decision” and that the more the BoC could get the economy on “solid footing” ahead of the shock, the better. We think the mere possibility of tariffs will keep the BoC on a dovish bias as it tries to prepare Canada for a potential shock. Unlike a provincial or federal government, the BoC doesn’t have to keep any “powder dry” for what’s ahead. The central bank has the luxury of preparing the economy with this cut, and, we expect, future cuts as inflation is now comfortably below 2% for three of the past four months. Put differently, the risks of excess easing are quite low in Canada, especially relative to the U.S.

2. The BoC is challenged by the complexity of modelling a tariff shock on Canada and the central bank’s role in it.

Similarly to how RBC Economics described the transmission of a tariff shock in Canada, the BoC engages in an illustrative example that highlights the challenges of measuring how badly a tariff would hurt an economy and how many assumptions would need to go into the forecast. Policymakers appear to have avoided the idea that a single number can neatly summarize the risks ahead. Governor Macklem adds that the central bank is busy running scenarios and engaging in outreach with Canadians.

Still, how the BoC would respond in a prolonged trade conflict isn’t clear. Governor Macklem said it would depend on what ended up dominating the economy once tariffs arrived—the downsides on growth or the upsides of inflation. However, there were some important takeaways about how the BoC may be thinking about its role:

• A tariff shock is a negative growth shock, but also increases inflation. It is, effectively, a “stagflationary” shock. The BoC noted it is “equally concerned about inflation rising above the 2% target or falling below it,” and there is both upside and downside risks surrounding the outlook. Our take is the BoC should focus on the downside risks around growth versus a supply-driven inflation shock (e.g. if the unemployment rate is rising, then even an inflation-targeting central bank would have to concede that rate hikes would do little to solve for inflation driven by tariffs except to create deflation in other areas of the economy). But, the BoC doesn’t appear to be determined on where it would land. That’s likely why it removed more explicit forward guidance from its statement (even as a dovish bias is clearly still in play).
• And yet, Governor Macklem emphasized that solving the damage to Canada’s economy couldn’t just be the bank’s job.

“Monetary policy cannot offset the economic consequences of a protracted trade conflict. The reality is the economy is going to work less efficiently, Canada’s going to produce less and going to earn less. Monetary policy cannot change that, it cannot offset it. It can help the economy adjust to that, a source of stability through that adjustment so that the adjustment is less unpleasant.”

(That reads like a call for fiscal policy to also help support the shock, though, of course, the BoC cannot opine directly on this topic). It also is another nod to the challenges of a stagflationary shock for a central bank, where the best course of action will remain murky even as details of a trade conflict materialize.

The Bottom Line:

• As expected, the Bank of Canada today cut the overnight rate by another 50 bps to 3.25%, right to the top end of the BoC’s “neutral” range estimate (2.25% – 3.25%).
• Macklem’s opening statement made clear that with interest rates no longer “clearly in restrictive territory,”, the central bank will take “a more gradual approach” to monetary policy adjustments moving forward. That’s in line with our own forecast that expects the BoC will downshift to 25-bps reductions in their future meetings in 2025.
• We continue to expect that a weak economy will push the BoC to cut the overnight rate all the ways down to a stimulative 2%.

The Details (meeting recap):

• Today’s 50-bps cut was the second consecutive larger than “usual” reduction after the 50bp reduction in October and a string of earlier, smaller 25 bp cuts that started in June. The overnight rate has now been reduced by 175 bps in total.
• The acceleration in rate cuts came amid growing signs of persistent softening in economic activities and labour market conditions – GDP growth undershot the BoC’s forecast in Q3 and looks poised to undershoot again in Q4. The unemployment rate in Canada at 6.8% in November has risen by 1% since last year, or 2% since July 2022 when conditions were overheating.
• Overall, a soft domestic backdrop suggests the future path for inflation in Canada is still more likely lower rather than higher. A couple of things however are clouding that outlook.
• For one, the pace of immigration is set to slow sharply in 2025 and 2026, underpinning expectations that population growth in Canada will grind to a halt for the first time on record. The BoC in their statement expects slower growth as a result, but “muted” impact on inflation as lower immigration hampers both demand and supply in the economy.
• The possibility of trade disruptions was also mentioned as “a major new uncertainty”, although comments around that were fairly vague (rightly so) given enormous uncertainties associated with possible scenarios.
• Finally, the GST tax holiday scheduled to start mid-December and end by mid-February got an honorable mention. It will mechanically bias the headline inflation readings lower (as CPI prices include indirect taxes), but could actually work to increase underlying price growth by stimulating demand.
• The BoC suggested to look at the core measures (CPI trim, median) instead, that strip out related effects and should offer a better gauge of inflation pressures during those months.
• Circling back to the growth backdrop, in Q3 there were already tentative signs that economic activities, especially those that are interest-rate sensitive (consumer spending, housing) are picking up. Still, business spending was softer and there is still slack in the economy. Interest rate cuts will continue to work to stimulate activities, especially labour market, with a significant lag.
• We expect per-person GDP to remain soft in the near-term, and unemployment rate will keep edging higher before leveling out at round 7% early in 2025. Persistent softening in the economy into 2025 should ultimately motivate the Bank of Canada to cut rates down to stimulative territory, at 2%.

The Bottom Line:

• The BoC made the leap to cut the overnight rate by 50 bps today, amid accumulating evidence that the economy and labour markets are weakening by more than what is necessary to achieve the 2% inflation target.
• The reduction won’t be the last one. The level of the overnight rate is still restrictive at 3.75% and the BoC in the press release hinted at future rate cuts will follow to support a return to stronger GDP growth.

Impact to Our Forecasts:

• We continue to expect one more 50-bps rate cut from the BoC this December to bring the overnight rate to the top end of the BoC’s estimate of its neutral range (3.25%) before a return to a more gradual pace of easing in 2025.
• Our base-case macroeconomic forecasts are weaker than the BoC’s. We think real GDP growth is more likely to stay subdued for longer in Canada as interest rates remain restrictive until 2025.
• We expect GDP growth of 1.3% in 2025, below the BoC’s projection of 2.1% and not meaningfully different from ~1% growth expected for this year.
• We also expect labour markets will continue to soften, with unemployment rate rising to 7% in the coming quarters and for softening activities combined to bring more disinflationary pressures in 2025.
• In terms of the terminal level of interest rates, we think BoC will cut to 2% by July next year, stimulative and a touch below the lower bound of the BoC’s own estimates of neutral rate at 2.25% – 3.25%.

The Details (meeting recap):

• BoC’s rate cut today was close to fully priced in in markets ahead of the meeting. Adding to odds of the 50-bps cut were the Q3 Business Outlook Survey and September’s inflation data last week, both pointed to lower present and future expected inflation in Canada.
• Governor Macklem led off his press conference saying that “we are back to low inflation” in Canada. Rather than focusing on a weak economy and the disinflation pressures that could follow, the BoC today highlighted balanced risks on inflation.
• On the upside, shelter and wage growth remain the main concerns but are both expected to slow. On the downside, a slower economic recovery (as we are anticipating) is “the biggest risk”.
• With the output gap still deeply negative (the BoC’s estimate was -0.75% to -1.75% in Q3) and monetary policy still restrictive, we think it’ll take longer for demand to rebound and excess supply in the economy to be absorbed.
• Rate cuts will boost the economy with a lag. Even with interest rates moving lower, many borrowers can continue to expect debt payments to go up in the years ahead. That speaks to more urgency to “front-load” the easing.

• The BoC lowered the overnight rate by 25 basis points for a third straight meeting, adding to cuts in each of June and July. The move was in line with market and our own expectations ahead of the announcement.
• Governor Macklem’s opening statement for the press conference was again dovish, highlighting a shift in the central bank’s focus to a gradually weakening economy and for that to put further downward pressure on inflation. The BoC reiterated that it is “reasonable to expect further cuts” as long as those expectations are confirmed in the data.
• Data to-date has been cooperating. As mentioned in the opening statement a slew of different inflation measures are all returning back closer to pre-pandemic “normal” levels. That puts Inflation concerns more and more on the back burner.
• The BoC’s forecast in July was for core inflation (average of CPI trim and CPI median) to slow to 2.5% on a year-over-year basis in Q3. Latest in July, those measures were averaging at 2.6%.
• Moving forward, as much as high inflation is not welcome by the central bank, below-target inflation is also a growing concern, speaking to rising downside risks to both the economy and inflation relative to the central bank’s latest forecast.
• Indeed, the Canadian economy as the BoC indicated, remains in the state of excess supply in Q2 with the 2.1% quarterly annualized GDP growth once again falling short of potential GDP growth (estimated by the BoC at 2.4% for 2024) as surging population boosts the available labour supply.
• Meantime, hiring demand in Canada has slowed and struggled to keep up with rising labour supply. That has led the BoC again to expect still-elevated wage growth (particularly relative to soft labour productivity growth numbers) will continue to moderate in the period ahead.

Bottom line:

The third straight interest rate cut in September from the BoC still leaves the overnight rate at relatively high (‘restrictive’) levels – particularly compared to a softening economic growth backdrop that’s expected to keep inflation on a downward trajectory. Despite some pockets of sticky price growth (shelter and “some” other services), the tone from the BoC has clearly shifted to worrying about a gradually but persistently weakening economy. Already, growth in the third quarter is looking to undershoot the BoC’s July forecast of 2.8%. We continue to expect the BoC to follow with another rate cut in October.

• After a first interest rate cut in June, the Bank of Canada again lowered its key overnight rate by 25 basis points to 4.5%. The move was in line with market and our own expectations ahead of the announcement.
• Governor Macklem’s opening statement for the press conference was more dovish than the rate announcement. The governor highlighted a reasonable expectation for future rate cuts should inflation continue to ease in line with BoC’s forecast. He also discussed the balance of risk to inflation, and highlighted an increase in weight to the downside.
• On the downside, the BoC focused on the state of the Canadian economy, more specifically increased excess supply as indications that inflation pressures should continue to unwind.
• Indeed, growth in the economy is expected to have decelerated again in the second quarter after slowing in Q1, leaving a bigger gap with potential GDP growth that’s still propped up by the rise in population. Although the BoC expects the government’s target on non-permanent residents should reduce population growth in 2025.
• On the upside, the BoC highlighted several corners in the consumer basket that are still seeing elevated inflation, including shelter and other services (dining out at restaurants and personal care) that are labour heavy and therefore more closely affected by elevated wage growth.
• On each of those pressure points there have been early evidence that inflation’s unwinding. Growth in rent prices especially in major markets appeared to have ground to a halt into the summer. CPI growth due to mortgage interest costs should slow naturally as interest rates decline. Finally, progressively weaker labour markets and businesses’ sentiment were all for wage growth to keep normalizing in the year ahead.
• Moving forward and similar to our own forecast, the BoC expects unwinding in price pressures will persist and economic conditions in Canada will gradually improve. The BoC’s forecast is for their preferred core inflation measures to slow to 2.5% over the second half of 2024 from 2.7% in Q2, and slow further to reach the 2% target in 2025.

Bottom line:

The interest rate cut today from the Bank of Canada marks a continuation in the central bank’s effort to lower interest rates back towards “normal” levels, amid signs of slowing inflation. The BoC highlighted parts of the economy that are still seeing abnormally high pressure in price growth, but also thinks a weaker economic and labour market backdrop, as well as increased excess supply should continue to propel inflation back towards the target level this year and next. Against that backdrop, our expectation remains that there will be two additional rate cuts this year, one at each meeting after today’s meeting that will lower the overnight rate to a still restrictive 4% by the end of 2024.