While central bankers continue to talk tough about clamping down on inflation, financial markets are questioning how resolute they will be if price pressures ease and economic growth stalls in the coming quarters as expected.
After raising interest rates aggressively over the past year in an attempt to curb consumer spending and slow price increases, a number of major central banks are reaching a pivot point for monetary policy. The Bank of Canada announced a “conditional pause” to interest rate hikes last week. The Bank of England seemed to follow suit on Thursday, announcing another rate hike while suggesting that borrowing costs may be high enough to get inflation under control.
Central bankers have argued that pausing rate increases does not mean they’re about to start cutting rates, and The Bank of Canada hasn’t ruled out further rate hikes if inflation proves stickier than expected.
But financial markets aren’t so sure. Bond yields have fallen sharply in recent months, as investors have begun betting that central banks will ease off their monetary policy brakes sooner than previously expected.
Interest rate swaps, which are based on market expectations about future rate decisions, are pricing in at least one Bank of Canada rate cut later this year, and additional cuts in 2024. Even in the United States, where the Federal Reserve said this week that it intends to keep tightening monetary policy, markets are pricing in two quarter-point rate cuts before the end of the year.
Markets are often wrong, and they are prone to misreading cues from central bankers. But they are responding to a real improvement in inflation, which has declined in many countries in recent months as oil prices have dropped and supply chains have improved, bringing down goods prices. They are also betting that central bankers will about-face when and if economic growth grinds to a halt.
The Bank of Canada’s benchmark interest rate is currently at 4.5 per cent, the highest level since 2007.
“If anything, I think the [Bank of Canada] could go a bit quicker than markets are currently pricing in,” said Stephen Brown, senior Canada economist with Capital Economics.
“Once the bank has become convinced that inflation will return to target, there isn’t really any reason to keep rates at that high level.”
It could still take a considerable amount of time for the Bank of Canada to become confident about the trajectory of inflation. The annual rate of consumer price index growth has trended down since the summer, hitting 6.3 per cent in December from a high of 8.1 per cent in June. The bank’s target inflation rate is 2 per cent.
Higher interest rates are hammering the housing market and have started to weigh on consumer spending – something the central bank wants to see as it actively engineers an economic slowdown.
But service prices continue to rise quickly, fuelled by a tight labour market and rising wages.
“It’s far too early to be talking about cuts,” Bank of Canada Governor Tiff Macklem said at a news conference last week, after the bank delivered its latest quarter-point rate increase. “Yes, recent developments have reinforced our confidence that inflation is coming down. But we have a long way to go to get back to our 2-per-cent target.”
Federal Reserve chair Jerome Powell struck a similar tone after the Fed announced its eighth consecutive rate hike on Wednesday. He said that “the disinflationary process has started,” but warned that it would be “very premature to declare victory.”
Whatever central bankers believe about the trajectory of rates, don’t expect them to change their tune about rate cuts any time soon, said Toronto-Dominion Bank chief economist Beata Caranci.
Financial conditions have already loosened considerably in recent months, as optimistic investors have pushed bond prices higher and yields lower. This is working at cross-purposes to central bank efforts to make borrowing more expensive, and policy makers will be wary of reinforcing the decline in bond yields with dovish communications.
“You can’t possibly entertain the notion of cuts when you’re still not even out of the first stage of your cycle of tightening,” Ms. Caranci said. “I wouldn’t expect them to communicate cuts until they are really within a meeting of cutting them.”
Economists from the International Monetary Fund have urged central bankers to push back on market pricing, lest financial conditions ease too much and undercut progress against inflation.
“To be sure, this is an unusual period in which many special factors are affecting inflation, and it is possible that inflation comes down more quickly than policy makers envision,” Tobias Adrian, head of the IMF’s monetary and capital markets department, wrote in a blog post this week with two colleagues.
“However, loosening prematurely could risk a sharp resurgence in inflation once activity rebounds, leaving countries susceptible to further shocks which could de-anchor inflation expectations.”
With the Bank of Canada in a holding pattern, debate on Bay Street is no longer about how high rates will go. Now, the dominant topic of discussion is the timing and depth of rate cuts. Market pricing currently implies a roughly 2-percentage-point drop in the bank’s policy rate by the end of 2024.
Canadian Imperial Bank of Commerce rate strategists Ian Pollick, Sarah Ying and Arjun Ananth said in a note to clients that the magnitude of these expected cuts is reasonable. They plugged numbers into five different monetary policy “rules” – models used to assess the appropriate stance of monetary policy – and found an average prescribed policy rate of 2.39 per cent by the end of 2024.
But they think markets are jumping the gun by pricing in rate cuts later this year. Federal and provincial governments could still add to inflationary pressures with additional spending in their spring budgets. And the “real” policy rate – the bank’s benchmark rate minus the rate of inflation – won’t be high enough to act as a major drag on growth until inflation falls further.
“The fact that the real policy rate won’t turn truly restrictive until much later this year, in addition to fiscal policy risks looming, suggests the allocation of initial cuts are likely premature,” they wrote.
Economists have also begun grappling with the question of whether interest rates will remain higher than before the COVID-19 pandemic for structural reasons.
Many of the forces that put downward pressure on prices over the past three decades appear to be reversing. Populations are aging, leading to a relative shortage of workers. The process of globalization has stalled, as geopolitical tensions push countries into rival trading blocs and companies rejig their supply chains to avoid the kind of disruptions seen during the pandemic.
“Overall, the pandemic has accelerated structural changes in goods and labour markets that are likely to put pressure on goods prices and wages in the medium and long term,” Oleksiy Kryvtsov, Jim MacGee and Luis Uzeda, three top researchers at the Bank of Canada, wrote in a paper published last week.
“The resulting shifts in relative prices for goods and services and in costs for labour are unlikely to be large enough to threaten a return to the inflation target. But they may require central banks to return to higher interest rates, perhaps like those observed during the 2000-06 period.”
The Bank of Canada’s policy interest rate averaged around 3.5 per cent through that period.
The bank has not formally made an upward revision to its estimate of the “neutral rate” – the theoretical level that interest rates should settle at if inflation is on target and the economy is operating at full potential. Its last revision, in the spring of 2022, put the neutral rate in the 2 per cent to 3 per cent range.
Stephen Williamson, an economics professor at the University of Western Ontario, said the neutral rate may have moved up since then, because of the huge issuance of government debt in Canada and around the world during the pandemic. But it’s tough to know where this new steady level might be, he said.
“It could be that before they have a chance to even think about that, the next recession comes … And you know that when the next recession comes, interest rates go down again, and then they start over again.”