News & analysis

The Bank of Canada today held rates at 5% for the second consecutive meeting since it resumed its hiking cycle with two consecutive 25bp hikes in June and July. The decision to hold was in line with our view as well as the market and economist consensus.

The Bank noted that while inflation has exceeded its projections in the third quarter due to an unforeseen increase in energy prices, weaker growth and emerging slack in the labour market have largely offset the risk to its medium-term inflation projections. Staff projections thus maintained the view that inflation would return to the Bank’s 2% target by the middle of 2025. While the BoC acknowledged signs of slowing demand, disinflation progress in sub-components such as services ex. shelter, and a narrowing in the breadth of inflation pressures, the lack of progress in overall core measures of inflation—which are tracking between 3.5% and 4% annualised—as well as strong wage growth have led them to retain their hiking bias. In the press conference, Macklem clarified that the impact of the war between Israel and Hamas on oil prices and global supply chains have underpinned the increase in inflation risk.

The persistence of inflation over the past few months has primarily been driven by rising shelter costs and an uptick in fuel prices.

While the BoC will likely look through the impact of the latter, it notes that unlike in previous cycles higher mortgage costs are not being offset by falling house price-related components, which have also risen in sympathy this time around due to structural supply constraints and high demand. That being said, Macklem noted in the press conference that the playbook for a renewed oil price shock is different in the context of high inflation expectations and a long period of above-target inflation. Specifically, he suggested that the BoC could react if higher energy costs fed through to core price pressures, and while the MPR raised the oil price assumption by $10 to $90/bbl, a sharp deterioration in the geopolitical backdrop could result in even higher prices than assumed.

Although we expect domestic inflation pressures to moderate further as the economy moves into excess supply, it is unsurprising that the BoC didn’t take much confidence in this view as doing so would likely stoke expectations of earlier and more aggressive easing in markets.

As growth conditions ease further and make the disinflationary process more clear, however, this hawkish message will become an increasingly difficult sell to markets. Nevertheless, the threat of further hikes has grown more credible, with Macklem repeatedly emphasising his discomfort with the persistence of core inflation. Core inflation has trended sideways since last summer, and yet the Bank has generally tolerated the lack of progress in holding policy rates flat at most of this year’s meetings. Macklem’s patience is beginning to run thin, stating clearly that core needs to move down, or rates could go higher. This seems to suggest that a continued flat trend in core will be viewed more pessimistically going forward, and have a greater weight on the policy reaction function.

In the immediate reaction to the release, the loonie weakened by a quarter of a percent to reach its lowest level since March, while the 2-year yield fell by 5bps.

Clearly, the market initially viewed this as more dovish than expected, particularly due to the acknowledgement of clearer downward pressures on demand and the impact this was having on some sub-components of inflation. While slight CAD weakness was foreseeable due to the residual risk of a hike priced into markets, the loonie initially weakened further than we would have expected since markets had priced a 95% chance of a hold today. Additionally, the mention of higher inflationary risks and the continued insistence that further hikes remain on the table should have arguably dulled the dovish edge of the demand discussion. Since then, the Canadian dollar has fully reversed its initial weakness, which we view as sensible given the balanced mix of hawkish and dovish comments.

BoC downgrades growth, but remains cautious on the responsiveness of inflation 

With the Bank of Canada meeting expectations and holding its policy rate at 5%, the emphasis for markets largely rested on its updated economic projections and how staff would view weaker growth and higher inflation data since July’s MPR. Namely, markets were focused on the BoC’s assessment of when the output gap was set to normalise, developments in inflation expectations, wage growth, and corporate pricing behaviour; the four metrics the BoC now states as key in monitoring to assess whether policy is well calibrated.

The most notable development came in the Bank’s assessment of excess demand. Reflecting weaker Q2 growth, due to weaker-than-expected household spending and a larger negative impact from forest fires and public sector strikes than initially estimated, the Bank now views the economy in slight excess supply, 3-months earlier than anticipated in July. Furthermore, Bank staff estimate that excess supply will build throughout the forecast horizon.

In the medium-term, growth is expected to remain muted, averaging less than 1% over the next several quarters, leading to an increase in economic slack over the next twelve months before demand picks back up again as the drag from past monetary policy actions fade.

All else equal, this should maintain progress on disinflation even as policy remains on hold, as suggested by the Bank’s view that inflation will return back to 2% by 2025.

BoC’s estimates clearly show that monetary policy has weighed on demand

While in isolation the negative revisions to the Bank’s growth forecasts suggests the hiking cycle is over, the Bank has repeatedly stressed that upside risks to its inflation forecasts have increased, even as it has marginally increased its 2024 and 2025 inflation forecasts from 2.5% and 2.1% to 3% and 2.2% respectively.

These risks largely pertain to external factors, such as an escalation in geopolitical conflicts and the impact that will have on oil prices and supply chains, but the Bank has also stressed the slower pace of progress in core inflation than it originally anticipated. While BoC staff did considerable work in decomposing the drivers of inflation persistence in an attempt to reduce concerns that inflation will remain stuck above target for a sustained period of time, with the results suggesting the persistence largely derives from housing dynamics, they also note that wage growth and inflation expectations remain elevated, while the latest Business Outlook Survey saw firms adjusting prices more regularly and by larger amounts than normal.

By stressing these concerns, the Bank was effective in keeping its hiking bias credible even as the growth outlook was revised considerably lower.

This was compounded by BoC Governor Macklem in today’s press conference, where he stressed the Governing Council’s preference to be patient, but its willingness to hike rates further should progress on core remain absent. Nevertheless, given the progress in demand sensitive price components and our view that goods related inflation is likely to normalise further in the coming months, we continue to believe the BoC is done with hiking rates. The change in tone regarding the persistence of core inflation and the focus on geopolitically-driven inflation risks do suggest, however, that the tail risk of further tightening is higher than we judged prior to today’s decision.

Latest BoC forecasts downgrade growth while raising the inflation profile

 

 

Authors: 

Simon Harvey, Head of FX Analysis

Jay Zhao-Murray, FX Market Analyst

 

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