Bank of Canada balances growth and inflation risks as it eyes more cuts

The Bank of Canada has cut rates by another 25 basis points. But as it monitors what it calls opposing forces on inflation, signs of a slowing economy, how many more cuts are ahead? And how big could they get? Joining us now to discuss, Andrew Kelvin, Head of Canadian and Global Rates Strategy with TD Securities. Andrew, always great to have you here, particularly on the Bank of Canada day.

Thank you for having me. Pleasure to be here.

Let's get your reaction. There was a lot in there, whether it was the press conference, or the statement, the decision itself-- start breaking it down for us.

Sure. It was a bit of an interesting decision because it was all about the subtext. It was all about the nuance. Markets had fully priced in a 25 basis point cut. Amongst economists, the expectation for a 25 basis point cut was near unanimous. So the decision itself was seen as a bit of a foregone conclusion by the market.

I think what was interesting is when we're in transition periods, you kind of get mixed economic data. There's some things you can point to as signs of strength, some things you can point to as signs of weakness. It's a bit of a choose-your-own-adventure.

The bank really chose a very dovish negative path in what they chose to emphasize. There was a lot of focus on the need for the economy to perform a little bit better if they are able to achieve their 2% inflation target. They're talking about the progress towards 2% as though it was not a done deal, but there's clearly increasing confidence that we're going to get to 2%. And for me, if there was a big development, a big takeaway, it was a sort of re-emphasis, reiteration that they are symmetrical in how they think about the 2% inflation target. Inflation above 2% is equally problematic as inflation below 2%. So it's that focus that's been growing over the last few meetings on the downside risks, which, to my mind, was the news. To my mind, that's really what gave us sort of a dovish tint to this meeting. And that's where the news was.

I always print off the statement ahead of it being delivered, and the same things were jumping out to me. Tiff Macklem saying, we need to increasingly guard against the risk that the economy is too weak, inflation falls too much. After going through that whole period of high borrowing costs because inflation was so stubborn, these lines really jumped out to me in terms of, we care about inflation being below the target as we do above. The economy functions well. Are they starting to worry now that they're behind the curve?

I think they would never tell you that--

Hey, we're behind the curve. Sorry about that.

Clearly, that is starting to seep into the thought process here, because if you contrast that to how they sounded in April and June when we were about to start cutting rates or very early in the easing cycle, it was always this sort of emphasis like, rates are going to move lower, but only if the inflation outlook allows us to. It was always very carefully hinged to rate cuts will depend on inflation moving lower.

And, hey, don't worry, if inflation doesn't move lower, we'll stop cutting rates. We're committed to getting down to 2%. Now, a lot more of the focus is on, we are not going to wait too long. The focus is on making sure that the economy doesn't suffer needlessly. It really has been this creep from being really focused on making sure they don't cut too quickly, to now it seems like making sure they don't cut too slowly.

They talk twice in the opening statement about opposing forces. This felt new to me as well, how they're defining it now. Because you and I have talked about it all along, the fact that if you stripped out shelter costs, inflation was already where it needed to be. They're calling that an opposing force now. What are they trying to get at there?

So, again, it kind of goes back to this notion. It's like, what are they trying to emphasize? Because if the Bank of Canada had been inclined to push back on future rate cut expectations-- and I'm going to have to be very careful today to say "cut" when I mean cut and not "hike," because that can be challenging when we switch from cutting cycles. The bank has chosen to really emphasize some of the things that would argue against additional rate cuts-- they could have focused on the fact that shelter inflation remains elevated.

Services inflation, broadly, is above their target. Three-month annualized core inflation is running about 2.5%. So the inflation momentum is not yet pointing to a return to 2%. And in the statement, it talks about shelter price being a large contributor to inflation, but it's showing signs of easing. And then they said some other services are also showing inflation, which struck me as, I don't want use the word "flippant," but it was very comfortable dismissing the fact that there was a sort of core of services inflation that would remain above 2%.

They're very comfortable with the idea that there's enough slack in the economy that inflation should move lower. And I think that really explains their comfort with talking about the move to 2% so it's now two-sided. They think that the economy has softened enough. They'll get the unemployment rate-- 6.4%, 6.5%. And, in their view, the economy is weakened sufficiently that they don't need to worry about cutting too quickly.

For them, it seems like the risks are more balanced. And I think in their heart of hearts, they, given the sort of direction where we're going in, it sure sounds like they're worried about cutting too slowly.

If they're worried about cutting too slowly, they laid out, as you said, this very dovish tilt in the opening statements from Governor Macklem. The first question out of the gate when people got to ask some questions, like, why not 50 basis points, then, given what you've given us today?

And there's also the second question. Additionally, although he must have known this was going to be the first question he was going to get, there was an awfully long pause on that. He collected his thoughts. It's a responsible thing to do.

So there was a strong consensus for a 25 basis point move. And then governing council discussed a variety of scenarios, which is, again, the responsible thing for them to be doing. For them to not consider the circumstances in which they would cut by 50 basis points, then they're not doing their jobs, really simply.

So the way it was sort of framed was that there was a strong consensus to cut by 25 basis points today. And in the future, if it turns out that the economy deteriorates further, perhaps they'll need to increase the pace of rate cuts. Conversely, if inflation proves stickier, if some other segments of the services sector that are showing sticky inflation, if it remains sticky, well, perhaps they'll have to slow. Perhaps they'll have to take pauses at some point in the future.

When I think about a 50 basis point cut, though, I think about an economy that is materially weaker than what we've seen so far in Canada. That's not to say that the economy couldn't deteriorate from here. It's not to say that there aren't versions of this world where they will need to start cutting by 50. But right now, we're talking about Q4-over-Q4 growth in Canada around 1.5%.

That's not great when we're growing the population at around 3.5% per year. Clearly, there are some pockets of extreme weakness in the labor market around sort of new entrants to the labor force-- young people, that sort of thing. But the aggregate growth numbers-- and, keep in mind, inflation is above 2%.

For them to cut by 50 basis points, because the expectation that the market won't be that they'll do 50 and go back to 25-- the market will start pricing in a lower terminal rate. The market will start pricing in additional 50 basis point cuts. The market will run with that if they were to cut by 50. That would be a lot of easing going into the economy, which would strike me as a real gamble when you haven't seen really significant weakness in growth in aggregate so far and when inflation is again still running above 2%. I do believe that they should probably be imminently achieving their inflation target before they even consider cutting by 50 basis points, absent a sort of tail scenario as we saw in 2020.

Now, you mentioned terminal rate there-- the end point of all this, now that we've started the cutting cycle here in Canada. How do you see the rest of this year playing out? Where do we end up next year?

So we think they'll cut again in October and December. They just sounded sufficiently dovish to me. When you heard them in the press conference when we read the statement, they just seem like they are really looking for reasons to continue easing. I think the path they have in their mind is several consecutive 25 basis point cuts, perhaps all the way back down to their neutral rate.

So we think for October and December, we see 25 basis point rate cuts. It would probably take a lot to get the Bank of Canada to pause in October. It'd be a monumental 180 in the sort of view and sentiment around the economy for them to pause in October. I think October pause is, for me, becoming very difficult to see.

December-- there's a lot more time between now and December than now and October. There's always scope for them to have the weight of data cause them to change their biases, or their leans, or their intuition again. So you never want to say any of these things are done deals, but given their recent sort of reveal dovishness, and given that we do expect pretty mediocre growth and a bit more improvement on the inflation front through the rest of 2024, we think October and December make sense for rate cuts.

When we get into 2025, we do think that, perhaps, the pace of easing slows. Right now, we don't expect them to hit 3% until sometime in the second half of 2025-- Q4 2025. So we do think we will see a pause at some point next year given that inflation is lingering above 2%.

But that, again, will be heavily dependent on the data. And the point I will just make is we are using a 3% assumption for the terminal rate. We think that's where neutral rates are in Canada at TD Securities. If we get to 2% inflation and you still have this much slack in the economy-- so if we get to 2% inflation and we don't see a re acceleration of growth at any point next year, that would argue for a move below neutral. That would argue for, actually, accommodative monetary policy in 2025, which is probably something they have in the back of their minds as they go through these discussions. If we're going to need accommodative policy at some point next year, maybe that's a good reason for moving in more consecutive 25 basis point increments this year.

[MUSIC PLAYING]