Will BOC cut further in 2024 after font loading -75 bps?

·         Bank of Canada cuts three times consecutively in June, July, and September; present repo rate at +4.50% against Fed’s expected +5.00% by Dec’24

·         BOC needs to bring down 6MRA core inflation and also unemployment rate by around -1.0% each to meet its pre-COVID economic conditions against the repo rate of +2.00%

·         BOC may like to keep a neutral rate of at least +50/100 bps positive from 6MRA of core inflation against the Fed’s +75/100 bps

·         Like BOC, the market may be also expecting similar back-to-back Fed rate cuts in Sep+Nov+Dec’24; but the Fed may cut only in Sep and Dec’24 @-25 bps.

Last Wednesday (4th September) some market focus was on the Bank of Canada (BOC) policy decision as BOC is traditionally seen as a small proxy of the Fed due to similarities between the two northern American neighbors.  As unanimously expected, BOC cut all three policy rates for the 3rd consecutive time since June’24; i.e. target for the overnight interbank rate to +4.25%; bank rate (repo rate) to +4.50% and deposit rate (reverse repo rate-main policy rate) to +4.25%.

The BOC cut all three policy rates in Sep’24 and the 3rd consecutive time since June’24 ahead of a series of State/Provincial elections from mid-Sep’24-Oct’24 and a highly probable Federal election by early 2025 or even late 2024 instead of scheduled mid-Oct’25. The BOC also front-loaded -75 bps rate cuts since June’24 for not only falling core inflation approaching the target but also to tackle rising unemployment and slack in the economy.

The BOC cut its key policy interest rate (repo) by -25 bps to +4.50% in Sep’24 as highly expected, to mark the third consecutive -25 bps cut after holding the hiking cycle’s terminal rate of +5.25% for 10 months. The Canadian central bank (BOC) noted that the front loading of rate cuts was warranted as excess supply in the Canadian economy continued to put downward pressure on inflation.

Additionally, BOC policymakers reiterated some concerns about undershooting inflation targets, adding to their worries of overtightening. Also aligning with the need for looser financial conditions, the BOC MPC/GC noted that the labor market continued to slow in recent months, although wage growth remains elevated when compared to productivity. Still, the BOC noted that inflation remains elevated for shelter and selected services, noting that upside risks to price growth are also present.

BOC/Canada Reverse Repo (deposit) rate

BOC Mandate/Policy Moto: “We are Canada's central bank. We work to preserve the value of money by keeping inflation low and stable.”

BOC MPC Full text: Bank of Canada reduces policy rate by 25 basis points to 4¼%

September 4, 2024

“The Bank of Canada today reduced its target for the overnight rate to 4¼%, with the Bank Rate at 4½% and the deposit rate at 4¼%. The Bank is continuing its policy of balance sheet normalization.

The global economy expanded by about 2½% in the second quarter, consistent with projections in the Bank’s July Monetary Policy Report (MPR). In the United States, economic growth was stronger than expected, led by consumption, but the labor market has slowed. Euro-area growth has been boosted by tourism and other services, while manufacturing has been soft. Inflation in both regions continues to moderate. In China, weak domestic demand weighed on economic growth. Global financial conditions have eased further since July, with declines in bond yields. The Canadian dollar has appreciated modestly, largely reflecting a lower US dollar. Oil prices are lower than assumed in the July MPR.

In Canada, the economy grew by 2.1% in the second quarter, led by government spending and business investment. This was slightly stronger than forecast in July, but preliminary indicators suggest that economic activity was soft through June and July. The labor market continues to slow, with little change in employment in recent months. Wage growth, however, remains elevated relative to productivity.

As expected, inflation slowed further to 2.5% in July. The Bank’s preferred measures of core inflation averaged around 2 ½% and the share of components of the consumer price index growing above 3% is roughly at its historical norm. High shelter price inflation is still the biggest contributor to total inflation but is starting to slow. Inflation also remains elevated in some other services.

With continued easing in broad inflationary pressures, the Governing Council decided to reduce the policy interest rate by a further 25 basis points. Excess supply in the economy continues to put downward pressure on inflation, while price increases in shelter and some other services are holding inflation up. The Governing Council is carefully assessing these opposing forces on inflation. Monetary policy decisions will be guided by incoming information and our assessment of their implications for the inflation outlook. The Bank remains resolute in its commitment to restoring price stability for Canadians.”

The opening statement of BOC Governor Macklem: 4th Sep’24

Today, we lowered the policy interest rates by 25 basis points to 4.25%. This is the third consecutive decrease since June.

Our decision reflects two main considerations.

First, headline and core inflation have continued to ease as expected.

Second, as inflation gets closer to the target, we want to see economic growth pick up to absorb the slack in the economy so inflation returns sustainably to the 2% target.

Inflation continues to reflect the push and pull of opposing forces. Overall weakness in the economy continues to pull inflation down. But price pressures in shelters and some other services are holding inflation up. Since the July Monetary Policy Report, the upward forces coming from prices for shelter and some other services have eased slightly. At the same time, the downward pressure coming from excess supply in the economy remains.

If inflation continues to ease broadly in line with our July forecast, it is reasonable to expect further cuts in our policy rate. We will continue to assess the opposing forces on inflation and take our monetary policy decisions one at a time.

Let me expand on what we’re seeing in the economy, and how that played into our deliberations.

In the second quarter, the economy grew by 2.1%, led by government spending and business investment. This was slightly stronger than forecast in July. Together with first-quarter growth of 1.8%, this suggests the economy grew by about 2% over the first half of 2024. That’s a healthy rebound from the near-zero growth we had in the second half of 2023. Our July projection has growth strengthening further in the second half of this year. Recent indicators suggest there is some downside risk to this pickup. In particular, preliminary indicators suggest that economic activity was soft through June and July, and employment growth has stalled in recent months.

The unemployment rate has risen over the last year to 6.4% in June and July. The rise is concentrated in youth and newcomers to Canada, who are finding it more difficult to get a job. Business layoffs remain moderate, but hiring has been weak. The slack in the labor market is expected to slow wage growth, which remains elevated relative to productivity.

Turning to price pressures, CPI inflation eased further to 2.5% in July, and our preferred measures of core inflation also moved lower. With the share of CPI components growing above 3% now around its historical norm, there is little evidence of broad-based price pressures. But shelter price inflation is still too high. It remains the biggest contributor to overall inflation, despite some early signs of easing. Inflation also remains elevated in some other services.

As outlined in our July forecast, inflation is expected to ease further in the months ahead. It may bump up later in the year as base-year effects unwind, and there is a risk that the upward forces on inflation could be stronger than expected. At the same time, with inflation getting closer to the target, we need to increasingly guard against the risk that the economy is too weak and inflation falls too much.

We are determined to get inflation down to the 2% target, and we want it to stay there. We care as much about inflation being below the target as we do above. The economy functions well when inflation is around 2%.

Let me conclude. With continued easing in broad inflationary pressures, the Governing Council decided to reduce the policy interest rate by a further 25 basis points. Excess supply in the economy continues to put downward pressure on inflation, while price increases in shelter and some other services are holding inflation up. The Governing Council is carefully assessing these opposing forces on inflation. Monetary policy decisions will be guided by incoming information and our assessment of their implications for the inflation outlook. The Bank remains resolute in its commitment to restoring price stability for Canadians.

Highlights of BOC Presser (Q&A) comments by BOC Governor Macklem: 4th Sep’24

·         If inflation continues to ease broadly in line with our July forecast, it is reasonable to expect further rate cuts.

·         There is little evidence of broad-based price pressures, but shelter price inflation is still too high.

·         The economy most likely grow by about 2% over the first half of 2024

·         As inflation gets closer to the target, we want to see economic growth pick up to absorb slack in the economy

·         The Canadian dollar has appreciated modestly, largely reflecting a lower USD, and oil prices are lower than assumed in the July monetary policy report

·         The Canadian labor market continues to slow but wage growth remains elevated relative to productivity

·         Inflation may bump up later in 2024; there is a risk that upward forces on inflation could be stronger than expected

·         Overall weakness in the Canadian economy is continuing to pull inflation down

·         Recent data suggest there is some downside risk to the bank's July projection of stronger growth in the second half of 2024

·         Preliminary indicators suggest economic activity was soft through June and July

·         High shelter price inflation is still the biggest contributor to total inflation, but it is starting to slow

·         BoC cites continued easing in broad inflationary pressures

·         BoC: Excess supply in the economy continues to put downward pressure on inflation, while price increases in shelter and some other services are holding inflation up

·         Bank of Canada interest rate decision: Rates lowered by 25 basis points

·         BoC Rate Decision Actual 4.25% (Forecast 4.25%, Previous 4.50%)

 

Conclusion:

Like the U.S. economy, the Canadian economy, and labor market, as well as core inflation, are also cooling down, but still, running quite hot, and average core inflation is also now around +3.0%, well above the +2.00% targets; overall disinflation process gathered momentum more in Canada than in the US, but BOC is quite cautious as this may be temporary due to elevated rent and service inflation.

Overall, BOC needs Canadian average core inflation (CPI TRIM + MEDIAN) of around +2.0% (from present 6MRA level +3.0%), and an unemployment rate of around 5.5% (from present 6MRA 6.5%) for normal/neutral terminal repo rate of +2.00% (reverse repo-bank rate +1.75%) from present repo rate 4.25%.

As per Taylor’s rule, for the US/Canada:

Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(4.5-2.00) =0+2+2.5=4.50% (By Dec’24)

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=4.5% (for 2023)

In Jan’20 (pre-COVID), the US Fed repo rate was at +1.75% against Canada's BOC repo rate of +2.00%; i.e. BOC had +25 bps positive spread in repo rate, which is now converted into -100 bps (Fed +5.50% and BOC +4.50%). Looking ahead, the Fed may cut -25 bps on 18th Sep’24 and also another -25 bps on 18th Dec’24 for a terminal rate of +5.00% by 2024. After COVID, the Fed cut its repo rate to +0.25%, while BOC kept it at +0.50%. In brief, BOC should maintain this +25 bps positive spread with the Fed in the longer run assuming the overall macro balance between the US and Canada returns to the pre-COVID average. In that scenario, BOC may keep its repo rate at +3.00% against the Fed’s +2.75% by not cutting further in 2024 and thrice each in 2025-26 against the Fed’s thrice.

But the BOC may also want to keep at least a -50 bps spread with the Fed’s repo rate in the longer run to keep USDCAD at around 1.40-1.30 zone rather than 1.30-1.20 to boost the natural resource/export heavy Canadian economy, and employment while keeping imported inflation under control. The Canadian economy is largely dependent on the US import of natural resources and also the US/Chinese export of consumer goods. Canada has also a big issue of oil transportation to the other side of the Atlantic or Pacific and thus exports most of the oil to the neighboring US at a big discount. Thus Canada has to keep a stable currency for trade equilibrium and can’t diverge too much from the Fed, everything being equal. Thus BOC may also keep its terminal repo rate at +2.50% in the longer run against the Fed’s +2.75% by cutting four times in 2025 and 2026 in line with Fed.

Bottom line:

BOC has already front-loaded -75 bps rate cuts against the fed’s projected -50 bps rate cuts by Dec’24. Looking ahead BOC may not cut further in 2024. In 2025-26, depending upon actual real policy, and inflation spread, BOC may cut thrice or four times each to keep an appropriate real yield/policy rate differential with the Fed. BOC may also want to keep a watch on the next Canadian general election in early 2025, where incumbent PM Trudeau may lose the election and the opposition party may have a plan for fiscal expansion to boost Canadian employment, which is structurally high.

Looking ahead, whatever may be the narrative, technically USDCAD (1.36100) now has to sustain over 1.36500 for a further rally to 1.36800/1.37000-1.37600/1.38500-1.39000/1.39500 in the coming days; otherwise sustaining below 1.36400/1.26300, may again fall to 1.34400 and 1.33000.