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At its latest monetary policy meeting the Bank of Canada signaled progress is being made to cool inflation, but that the job isn’t done yet. Andrew Kelvin, Chief Canada Strategist with TD Securities, says the real challenge isn’t just lowering inflation but actually getting it back to 2%.
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* The Bank of Canada has held its key rate at 4 and 1/2%. It is seeing inflation pressures easing. But Governor Macklem also made it clear the bank is willing to raise rates again to get inflation back to its target range. Joining us now to discuss, Andrew Kelvin, Chief Canada Strategist with TD Securities. It's great to have you back, Andrew.
* Thank you for having me.
* All right. So as we said, the governor did make a point of saying, if we need to go higher-- because it is a conditional pause-- we will go higher. And then of course when he gets a chance to-- asked a direct question about the rate of-- the path of rates, he's asked about a cut. I mean, there's still this push-pull in the market. How are we supposed to read all this?
* Well, markets are pricing in BOC cuts later this year. Market pricing for the Bank of Canada really shifted with some of the banking turmoil we had in the United States, you know, about a month ago now. And so I think you need to look at everything the Bank of Canada said today, set against the context of a market that is biased towards seeing rate cuts not rate hikes. So I think there was a goal from the Bank of Canada today to maybe push back, directly or not-- it turned out it chose directly-- against this notion that rate cuts were in the offing from the BOC.
The big picture for them is, while they're encouraged by some of the progress we've made in inflation, on some level, this is almost the easy work. It's going to be much more difficult to get inflation from 3 and 1/2% to 2 and 1/2% and 2%. So they think the market price is a little bit premature, and they want to make sure it's understood that rates could be in restrictive territory for quite some time.
* What would it take for them-- let's run down the scenarios. What would it take for them to get off of pause, which they're on right now, to the upside-- to make good on this thing, saying, if we have to raise rates we will do it again to bring inflation under control? What would have to happen in the economy or with inflation for them to do that?
* Sure. And there's any number of permutations here. But the one I'm really focused on is around the labor market data. To get inflation back to 2%, we need to see service inflation decelerate, which means we probably need to see wage growth slow a little bit. Wage growth is as high as it is because the labor market is extremely tight.
The governor said in his press conference today that we do need to see a period of weakness to let some slack come into the economy, which would be slower job growth, which would be a higher unemployment rate. And the BOC's pause at 4.5% is entirely predicated on this idea that the economy is going to slow. Because they've already lifted rates more than four percentage points. If it turns out that they haven't lifted rates by enough to cause the economy to slow, due to whatever external factors you want to point to or just that they didn't hike enough to begin with, they ultimately would need to start tightening more.
So to my mind, if we keep running in the sort of growth we've seen in the first quarter, which is tracking about 2 and 1/2% GDP-- we've added, I think, 60,000 jobs per month over the last two quarters on average. If we see numbers like that just continue into the second quarter or to Q3, the Bank of Canada may find their hand forced to have to lift rates again.
And I would just add, historically, when the bank moves to restricted territory, it's actually more common than not that they hike. They pause a bit because they think they're done, and they want to see what impact rate hikes are having. And then they decide they need to, oh no, hike again later on in the cycle, which is inevitably followed by a very quick reversal in history. But the idea that they'd pause and hike again is actually-- it's more historically consistent than the path which we are expecting, which the bank is expecting, which is that 4 and 1/2% is the top.
* That's an interesting perspective, historically. What about the other scenarios? Those are the conditions that perhaps would force the Bank of Canada to hike again, even though we're on a conditional pause. What would it take for the bond market to prevail, and to actually see a cut before the end of this year?
* So if we want to talk about a cut in December versus January, we're sort of quibbling a bit here. That would just be growth that's a little bit weaker than anticipated. I would just say that we are looking for growth that's going to be closer to 1% this year. The Bank of Canada is looking for 1.4%. They took a little bit more of the recent strength on board than we have.
So if we want to talk about a cut by the end of the year, which is where the bond market is, you just need to see growth slow a little bit more than anticipated in Q2 and Q3, and maybe a little bit less of a pullback in-- or rebound, I should, say in Q4. A recession would probably get you having a serious discussion about cutting rates in the fourth quarter.
But anything prior to that, we really need to be talking about a coordinated global downturn, like the sort of recession where you're having a debate if it's a recession or a depression. And right now, I see no indication that that's likely, particularly given that every day that goes by and we don't see new bad news out of the US banking sector, it makes it more unlikely that the banking sector is healing. So from that perspective, it looks like a very unlikely scenario to me that we'd be discussing rate cuts before the very end of this year. And really, we think cuts are a 2024 story, not a 2023 one.
* OK. We've also had an interesting-- because we had a monetary policy report, which is where the bank sort of reassesses its position on economic growth and where everything is headed. And they've had to factor in the fact that we've had a federal budget, provincial budgets. And there was a question asked point blank of the governor, saying, in these fiscal plans, do you see anything that's sort of going to stand in the way of your inflation fight?
I found his answer very interesting. He basically says, well, these budgets aren't standing in the way of bringing inflation down. I mean, you looked through all these documents. Are they inflationary or is the Bank of Canada on the right course here?
* I think the governor handled that question really well from an objective perspective, not just a political perspective. The budget is more inflationary than deflationary-- I'll put it that way-- to the extent that deficits are going to be larger, though there is a bit of new spending. That is something that is, just from an arithmetic perspective, inflationary. There's going to be a bit more demand because of the budgets.
But I don't think the numbers that we were talking about with that budget are enough to really change the broader narrative, to change the broader trajectory in where inflation is going and where the economy is going. And so to the governor's point, if you were to see significant spending cuts from the federal government, or tax raises or something of that like, you would see less demand. And that would help bring inflation under control. But I don't know that's something in the last set of budgets that I thought was going to make it materially more difficult for the Bank of Canada to bring inflation under control.
* Of course, inflation is the heart of this conversation about central banks, our central bank. We got a fresh read on US consumer prices. The market at first seemed to think, OK, inflation is pulling back. There's a bit of a rally, a bit of choppiness. How should we be reading this inflation report?
* So I think that rally you saw, after the US CPI data, really speaks to how jittery markets are. We can see very large moves on modest surprises on economic data. And I think markets had maybe been braced a little bit for an upside surprise not a downside surprise. And we had inflation come in a little bit softer than expected in the US. It was seen as a sign that the Fed might have to tighten less, all else equal.
But I would take it back to the Canadian situation. Because, I think Canada and the US, you're looking at fairly similar situations on the inflation front. Inflation is decelerating. This is good. But there's still quite a bit more work to be done. And because there's still quite a bit more work to be done for both the Fed and Bank of Canada, a very out-sized reaction in markets is probably unwarranted. Because we shouldn't be changing-- making large changes to the projected path of monetary policy based on a downside surprise of approximately 1/10 on inflation.
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* The Bank of Canada has held its key rate at 4 and 1/2%. It is seeing inflation pressures easing. But Governor Macklem also made it clear the bank is willing to raise rates again to get inflation back to its target range. Joining us now to discuss, Andrew Kelvin, Chief Canada Strategist with TD Securities. It's great to have you back, Andrew.
* Thank you for having me.
* All right. So as we said, the governor did make a point of saying, if we need to go higher-- because it is a conditional pause-- we will go higher. And then of course when he gets a chance to-- asked a direct question about the rate of-- the path of rates, he's asked about a cut. I mean, there's still this push-pull in the market. How are we supposed to read all this?
* Well, markets are pricing in BOC cuts later this year. Market pricing for the Bank of Canada really shifted with some of the banking turmoil we had in the United States, you know, about a month ago now. And so I think you need to look at everything the Bank of Canada said today, set against the context of a market that is biased towards seeing rate cuts not rate hikes. So I think there was a goal from the Bank of Canada today to maybe push back, directly or not-- it turned out it chose directly-- against this notion that rate cuts were in the offing from the BOC.
The big picture for them is, while they're encouraged by some of the progress we've made in inflation, on some level, this is almost the easy work. It's going to be much more difficult to get inflation from 3 and 1/2% to 2 and 1/2% and 2%. So they think the market price is a little bit premature, and they want to make sure it's understood that rates could be in restrictive territory for quite some time.
* What would it take for them-- let's run down the scenarios. What would it take for them to get off of pause, which they're on right now, to the upside-- to make good on this thing, saying, if we have to raise rates we will do it again to bring inflation under control? What would have to happen in the economy or with inflation for them to do that?
* Sure. And there's any number of permutations here. But the one I'm really focused on is around the labor market data. To get inflation back to 2%, we need to see service inflation decelerate, which means we probably need to see wage growth slow a little bit. Wage growth is as high as it is because the labor market is extremely tight.
The governor said in his press conference today that we do need to see a period of weakness to let some slack come into the economy, which would be slower job growth, which would be a higher unemployment rate. And the BOC's pause at 4.5% is entirely predicated on this idea that the economy is going to slow. Because they've already lifted rates more than four percentage points. If it turns out that they haven't lifted rates by enough to cause the economy to slow, due to whatever external factors you want to point to or just that they didn't hike enough to begin with, they ultimately would need to start tightening more.
So to my mind, if we keep running in the sort of growth we've seen in the first quarter, which is tracking about 2 and 1/2% GDP-- we've added, I think, 60,000 jobs per month over the last two quarters on average. If we see numbers like that just continue into the second quarter or to Q3, the Bank of Canada may find their hand forced to have to lift rates again.
And I would just add, historically, when the bank moves to restricted territory, it's actually more common than not that they hike. They pause a bit because they think they're done, and they want to see what impact rate hikes are having. And then they decide they need to, oh no, hike again later on in the cycle, which is inevitably followed by a very quick reversal in history. But the idea that they'd pause and hike again is actually-- it's more historically consistent than the path which we are expecting, which the bank is expecting, which is that 4 and 1/2% is the top.
* That's an interesting perspective, historically. What about the other scenarios? Those are the conditions that perhaps would force the Bank of Canada to hike again, even though we're on a conditional pause. What would it take for the bond market to prevail, and to actually see a cut before the end of this year?
* So if we want to talk about a cut in December versus January, we're sort of quibbling a bit here. That would just be growth that's a little bit weaker than anticipated. I would just say that we are looking for growth that's going to be closer to 1% this year. The Bank of Canada is looking for 1.4%. They took a little bit more of the recent strength on board than we have.
So if we want to talk about a cut by the end of the year, which is where the bond market is, you just need to see growth slow a little bit more than anticipated in Q2 and Q3, and maybe a little bit less of a pullback in-- or rebound, I should, say in Q4. A recession would probably get you having a serious discussion about cutting rates in the fourth quarter.
But anything prior to that, we really need to be talking about a coordinated global downturn, like the sort of recession where you're having a debate if it's a recession or a depression. And right now, I see no indication that that's likely, particularly given that every day that goes by and we don't see new bad news out of the US banking sector, it makes it more unlikely that the banking sector is healing. So from that perspective, it looks like a very unlikely scenario to me that we'd be discussing rate cuts before the very end of this year. And really, we think cuts are a 2024 story, not a 2023 one.
* OK. We've also had an interesting-- because we had a monetary policy report, which is where the bank sort of reassesses its position on economic growth and where everything is headed. And they've had to factor in the fact that we've had a federal budget, provincial budgets. And there was a question asked point blank of the governor, saying, in these fiscal plans, do you see anything that's sort of going to stand in the way of your inflation fight?
I found his answer very interesting. He basically says, well, these budgets aren't standing in the way of bringing inflation down. I mean, you looked through all these documents. Are they inflationary or is the Bank of Canada on the right course here?
* I think the governor handled that question really well from an objective perspective, not just a political perspective. The budget is more inflationary than deflationary-- I'll put it that way-- to the extent that deficits are going to be larger, though there is a bit of new spending. That is something that is, just from an arithmetic perspective, inflationary. There's going to be a bit more demand because of the budgets.
But I don't think the numbers that we were talking about with that budget are enough to really change the broader narrative, to change the broader trajectory in where inflation is going and where the economy is going. And so to the governor's point, if you were to see significant spending cuts from the federal government, or tax raises or something of that like, you would see less demand. And that would help bring inflation under control. But I don't know that's something in the last set of budgets that I thought was going to make it materially more difficult for the Bank of Canada to bring inflation under control.
* Of course, inflation is the heart of this conversation about central banks, our central bank. We got a fresh read on US consumer prices. The market at first seemed to think, OK, inflation is pulling back. There's a bit of a rally, a bit of choppiness. How should we be reading this inflation report?
* So I think that rally you saw, after the US CPI data, really speaks to how jittery markets are. We can see very large moves on modest surprises on economic data. And I think markets had maybe been braced a little bit for an upside surprise not a downside surprise. And we had inflation come in a little bit softer than expected in the US. It was seen as a sign that the Fed might have to tighten less, all else equal.
But I would take it back to the Canadian situation. Because, I think Canada and the US, you're looking at fairly similar situations on the inflation front. Inflation is decelerating. This is good. But there's still quite a bit more work to be done. And because there's still quite a bit more work to be done for both the Fed and Bank of Canada, a very out-sized reaction in markets is probably unwarranted. Because we shouldn't be changing-- making large changes to the projected path of monetary policy based on a downside surprise of approximately 1/10 on inflation.
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