Bank of Canada expected to hold rates, but could signal policy shift

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The Bank of Canada is widely expected to keep interest rates steady this week for the sixth consecutive time, although analysts are watching for a shift in tone that could open the door to rate cuts over the summer.

The central bank has held its policy rate at 5 per cent, a two-decade high, since July. But with the economy languishing and inflation back inside the bank’s target range, many Bay Street economists and traders expect monetary policy to pivot in the coming months, perhaps as early as June.

The next rate decision is on Wednesday. Until then, the question is how much Bank of Canada Governor Tiff Macklem wants to tip his hand.

“Our thought is that they’ll still try to keep their options open,” said Nathan Janzen, assistant chief economist at Royal Bank of Canada. He noted that the central bank stopped warning about potential rate hikes in January. Since then, he said, “they’ve been pretty non-committal about when the first interest rate cuts might come.”

One reason central bankers may opt to stand pat on Wednesday is that they don’t yet know what Ottawa’s fiscal path will be for the next year. The federal budget is set to be released next week.

Financial markets put the odds of a rate cut this week at around 20 per cent, according to Refintiv data. That rises to more than 60 per cent for a cut in June.

The Bank of Canada is using high interest rates to slow the economy and reduce upward pressure on prices. Mr. Macklem and his team have remained wary of bringing rates down too soon, especially considering the risk that real estate prices could surge as borrowing costs start to drop. But the argument for easing monetary policy has gained ground in recent months.

The past two inflation reports have been better than expected, with headline Consumer Price Index inflation slightly under 3 per cent in January and February – not all that far from the central bank’s 2-per-cent target. The bank’s preferred measures of core inflation, which strip out the most volatile prices, have also been trending in the right direction.

At this point, the biggest drivers of annual inflation are mortgage interest costs, which are directly tied to the bank’s past interest rate increases, and rising rents, which are linked to a structural mismatch between housing supply and population growth.

“It’s not because the economy is overheating and it’s not because households have too much purchasing power,” said Matthieu Arseneau, National Bank’s deputy chief economist.

He said the central bank is making an error by focusing on measures that put too much weight on shelter inflation, which tight monetary policy can’t improve. “The risk is they remain too tight for too long, and cause more damage to the economy that was not necessary in the medium term to get inflation down,” he said.

The Canadian economy is clearly struggling under the burden of high interest rates. Business insolvencies are up, and indicators of future sales are weak, according to a recent central bank survey of companies.

The latest employment numbers, published by Statistics Canada on Friday, showed an unexpected net decline of 2,200 jobs last month, while the unemployment rate jumped to 6.1 per cent, up from 5.8 per cent in February. Unemployment has risen a full percentage point over the past year.

“With the jobless rate pushing above 6 per cent, one can make the case that the labour market is no longer tight in Canada,” Bank of Montreal chief economist Doug Porter wrote in a note to clients.

Recent economic growth numbers have come in above the Bank of Canada’s forecast, and so far the country has avoided an outright recession. But headline gross domestic product figures are being juiced by rapid population growth. GDP per capita, by contrast, has been on a downward track over the past 18 months.

The bank will publish new economic growth and inflation forecasts on Wednesday in its quarterly Monetary Policy Report.

The picture is very different in the United States, where the economy continues to churn out strong growth and job creation numbers. U.S. households are less bogged down by mortgage debt than their Canadian counterparts, and labour productivity is far higher south of the border.

This divergence could put the Bank of Canada and the U.S. Federal Reserve on slightly different paths, with Canadian central bankers moving first and cutting more in 2024. But there are limits to how far the Bank of Canada can get ahead of the Fed. If Canada’s interest rates start dropping before those in the U.S., the Canadian dollar would weaken against the U.S. dollar, pushing up the cost of imports and potentially adding to inflation.

“On the currency side, it’s something they have to take into account,” RBC’s Mr. Janzen said.

“But if the economy is significantly underperforming, and that’s why you’re cutting interest rates at the Bank of Canada when the Fed might be more cautious, then to an extent you can be okay with a weaker currency. Because all it’s doing is really adding additional monetary policy stimulus at a time when you think the economy needs it.”

One other thing analysts will have an eye on this week is the Bank of Canada’s updated estimate of the “neutral rate,” which it typically publishes every April.

This is a long-run estimate of where the central bank’s policy rate would land if inflation were on target and the economy were growing at full potential. Essentially, it’s a Goldilocks level, above which monetary policy is considered restrictive and below which it is considered to be providing stimulus.

The bank currently estimates the neutral rate is somewhere between 2 per cent and 3 per cent, although some officials have suggested the true range may be slightly higher.

Canadian Imperial Bank of Commerce economists Avery Shenfeld and Ali Jaffery expect the central bank to raise its neutral rate estimate by a quarter percentage point this week, they said in a note to clients. Still, they cautioned against putting too much faith in the neutral rate as a roadmap for where interest rates will ultimately end up going.

“Markets will likely make a bigger deal out of the Bank and eventually the Fed’s reassessment of neutral than they should,” Mr. Shenfeld and Mr. Jaffery wrote.

“But we don’t expect central bankers to show a lot of confidence in these estimates. The neutral rate is just one way to assess the stance of monetary policy, but it is just so imprecise that it can be just as much of hazard as it can be a guide for policy.”