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Canada’s annual inflation rate in February unexpectedly cooled to 2.8 per cent, the slowest pace since June, and core inflation measures eased to more-than two-year lows.

Analysts had forecast inflation to accelerate to 3.1 per cent from 2.9 per cent in January. On the month, the consumer price index rose 0.3 per cent, less than a forecast 0.6 per cent rise.

Traders clearly weren’t positioned for this report and the immediate market reaction showed it. The Canadian dollar and government of Canada bond yields immediately tumbled. The loonie fell about a quarter of a cent against the U.S. dollar to 73.50 cents U.S., trading at its weakest levels of the year. The Canada two-year bond yield, which was nearly unchanged prior to the 830 am ET report, fell 8 basis points.

Money markets are now placing about 60 per cent odds that the Bank of Canada will pull the trigger on its first rate cut in June, up from less than 50 per cent odds prior to the data, according to Refinitiv Eikon data, which is based on implied probabilities in the overnight swaps market. Money markets are now placing more than an 80 per cent chance of looser monetary policy in place by July.

Even an early rate cut in April at the bank’s next policy meeting is no longer appearing a far-fetched bet, with markets pricing in slightly better than 25 per cent odds of monetary easing beginning that month.

Markets are pricing in a total of 75 basis points of cuts by the end of this year by both the Bank of Canada and the Federal Reserve. But today’s report and the credit market reaction to it suggest it might be Canada’s central bank to cut first - in June - whereas the Fed may hold off until July.

Canada’s inflation rate unexpectedly fell to 2.8% in February

The following table details how swaps markets are pricing in further moves in the Bank of Canada overnight rate, according to Refinitiv Eikon data as of 0835 am ET Tuesday. The current Bank of Canada overnight rate is 5 per cent. While the bank moves in quarter point increments, credit market implied rates fluctuate more fluidly and are constantly changing. Columns to the right are percentage probabilities of future rate moves.

Meeting DateExpected Target RateCutNo ChangeHike

And here’s how markets were pricing in monetary policy changes just prior to the inflation report:

Meeting DateExpected Target RateCutNo ChangeHike

Economists and market analysts are largely still predicting the first rate cut to arrive in June or July, although some are suggesting the Bank of Canada should at least consider a cut in April given the progress made on inflation. Here are how they are reacting in written commentaries:

Stephen Brown, deputy chief North America economist, Capital Economics

The surprise fall in headline inflation to 2.8%, from 2.9%, is further reason to expect the Bank of Canada to cut interest rates soon, although we still think the Bank will wait until June rather than springing a surprise at the April meeting. ...

Despite higher gasoline prices, the overall CPI rose by only 0.1% m/m in seasonally adjusted terms, pulling the three-month annualized rate down to just 1.2%. While Stats Can noted that consumers benefited from lower prices for cellular and internet services, the weakness of inflation pressures appears to have been broad-based, with the CPI-trim and CPI-median measures each rising by just 0.1% m/m for the second month running. The average three-month annualized rate fell to 2.9%, leaving it below 3% for the first time since April 2021.

While the data support our view that inflation will fall to 2% sooner than the Bank anticipates, Governor Tiff Macklem has told us that the Bank needs to see at least “a few” encouraging data points before it cuts interest rates. That suggests that a rate cut at the early April meeting, before the March CPI data are released, is still very unlikely. Nonetheless, our forecast for a cut in June is arguably now looking more likely.

Royce Mendes, managing director and head of macro strategy, Desjardins

Much of the increase in prices that was seen came from energy, with gasoline prices rising 4.0%. Excluding food and energy, prices rose just 0.1% in seasonally-adjusted terms, taking that core inflation measure down to 2.8% from 3.1% in January. The softening in price pressures was relatively broad based, although clothing and cell phone services did show pronounced declines in February.

The Bank of Canada’s preferred measures of core inflation also showed a marked deceleration in February. Core-Median and Core-Trim are now averaging 3.2% down from 3.4% in the prior month. Our bias-adjusted measures suggest that underlying inflation is even weaker, with the metrics now averaging just 2.7%. But even the Bank’s naïve indicators are moving in the right direction faster than their headline readings might suggest, with the three-month annualized rates of unadjusted Core-Median and Core-Trim averaging just 2.2%. Other measures of core inflation also moved lower. The three month annualized rate of CPIX, the Bank of Canada’s former favourite, is now averaging 0.0%. The share of components rising faster than 3% a year, a metric closely watched by Governor Macklem, has fallen to roughly 40% from 45% in January.

Monetary policymakers will be able to breathe a sigh of relief after seeing these numbers. We had been saying that underlying price pressures were weaker than what the Bank of Canada had been estimating, so this doesn’t change our view for upcoming monetary easing. We expect central bankers will sound more dovish in April, thereby setting up a rate cutting cycle beginning in June.

Douglas Porter, chief economist, BMO Capital Markets

It’s difficult to poke any holes in this report. We’re not the only analysts caught by surprise at how modest these inflation rates of the past two months have been (and especially in contrast to the high-side and sticky readings in the U.S.)—the Bank of Canada had projected Q1 inflation to average 3.2% in its January Monetary Policy Report, while we are now headed for 2.8%. That’s a big and welcome difference, but is it sustained enough for rate cuts? April still seems too early to be pulling the trigger on rate cuts, though it can’t be entirely ruled out if the Business Outlook Survey shows even more progress. The softness of the domestic economy and increasing slack driven by higher rates is helping put downward pressure on inflation, just as the BoC intended. At a minimum for April, look for the Bank to open the door to rate cuts. BMO continues to call for a June start to rate cuts, and this report certainly reinforces our conviction. ...

I know it’s out of fashion, and a trifle uncool, but ex. food & energy can’t help it, it’s still quite a useful tool (to paraphrase Martha & the Muffins). Last month saw Canada’s olde school core CPI step down to 2.8% y/y, exactly matching the mild headline rate and the lowest since the first half of 2021. What really stands out is the growing gap between the U.S. and Canada on this measure of underlying inflation. True, Canada has been lower than the U.S. on this front since the pandemic began. But, the gap is now nearly a full percentage point in Canada’s favour. And short-term trends are very mild, with the 3-month s.a. pace now just 1.3%, and not bad at 2.3% for six months. This widening gap, which may be due to softer underlying spending growth in Canada, is a solid argument for the BoC leading the Fed on the rate cut front.

Derek Holt, vice-president and head of capital markets economics, Scotiabank

Who doesn’t like lower inflation?? Yes of course it’s nice to see weaker inflation than everyone expected for a second consecutive month after all of the challenges that Canadians have faced over the years. I would, however, caution against overreacting.

One [reason] is that the BoC will require more than just a lousy couple of months of soft inflation data before deciding to pull the trigger on a rate cut and especially on meaningful rate cuts in a plural sense. All of their communications have pointed toward wanting to see durable evidence and having the confidence that it will persist before commencing a dialogue on easing. We’re not there yet. Nor is the Fed which keeps pushing out easing as a complicating external factor for the BoC via the exchange rate implications. A warning to the BoC is that the Fed got lulled into watching a soft patch only to see core inflation boomerang on it.

Second [reason] is that a considerable part of the softness may have been driven by temporary factors. ... These categories have idiosyncratic drivers that cannot be modelled.

Third [reason] is that some of the biggest categories remain under notable and ongoing upward pressure which suggests that inflation danger continues to lurk beneath the surface.

A key point to bear in mind ... is that reading the inflation tea leaves is much more difficult so far this year and particularly in terms of separating out what may signal persistence versus what does not. In all, this feels like the start of a party when everyone is first arriving amid great expectations for how the night may unfold. The evening is young, however, and we’ll just require more evidence before being able to pass greater judgement. ...

We have to step back and ask ourselves what has really changed in terms of inflation risk in the span of just a couple of months. Not much in my view. The BoC cannot do anything about last month’s inflation data but has to have a leery eye toward the balance of inflation risk going forward.

Productivity remains miserable and wages continue to explode with fresh wage settlements data pending release shortly and that will capture the effects of the deals with Quebec’s public sector unions and the multi-year consequences. Unit labour costs continue to rise out of control. Governments are adding more fiscal stimulus including budgets from Quebec, BC, and Alberta plus smaller provinces and with more stimulus likely in the cards from the Feds and Ontario. ...

Immigration remains ridiculously excessive relative to the ability of the country to house all of the new arrivals and accommodate them from an infrastructure shortfall perspective. The narrative that this is net demand stimulus to the economy is unchanged.

And there is a lot of pent-up housing demand on the sidelines that’s just chomping at the bit to drive a hot market.

Last, the economy is mildly rebounding to start the year and progress toward creating disinflationary slack is inadequate to date relative to the myriad of inflation drivers we’re dealing with.

So cut? On the back of two soft months of inflation data? I know I wouldn’t. The biggest risk in my opinion is nevertheless a central bank that has fouled up throughout the whole pandemic fouling up once again under pressure to ease prematurely. It took way to long to begin tightening while denying all of the inflation evidence. That made it have to tighten more than it would have had it acted faster. It went on pause and contributed to renewed pressures only to have to come back with more hikes. To ease too soon would be the final straw. It would be a high stakes gamble that could easily backfire and add another black mark against Macklem’s leadership in the role.

Katherine Judge, economist with CIBC

There was unambiguously good news on the inflation front in Canada in February. ... This is the second month in a row in which inflation has looked softer than expected, and with ample evidence that higher interest rates are working to tame inflation, the Bank of Canada is on track to start cutting interest rates in June. The Bank of Canada will look through the volatile categories ... with other core measures providing a better signal of inflation stemming from underlying demand. On that score, virtually every core measure looked more encouraging. Services ex. shelter inflation slowed to 1.6% y/y, showing that the sluggishness in consumer demand is working to tame inflation in that area, which also suggests a further slowdown in wage inflation ahead, something that the Bank is looking for in order to trim interest rates. ...

This report is clearly encouraging from the Bank of Canada’s perspective. It is the last inflation report that policymakers will receive before the April forecast update and announcement, and will allow policymakers room to sound more dovish at that meeting, even though they will likely want to wait to see more evidence of the labour market loosening before pulling the trigger on interest rate cuts in June.

Philip Petursson, chief investment strategist at IG Wealth Management

The 0.3% month-over-month print was much lower than the 0.6% consensus expectation and is sure to force a rethink of the potential for rate cuts by investors. The question is whether the much lower inflation is an anomaly or a trend. Given the recent Canadian economic data, a trend is more likely. Using the current 12-month average as our starting point, that would suggest a continued and gradual easing of inflation towards 2% on a year-over-year basis by mid-summer and right in the middle of the BoC’s target. If the Bank of Canada chooses to follow the same philosophy as what U.S. Federal Reserve Chair Powell laid out last fall, it will start to ease monetary policy ahead of reaching its target for risk of overshooting inflation to the downside. That would suggest the first cut comes ahead of the July meeting with a cut in April still solidly on the table.

With moderating economic growth, the potential for a rate cut by the Bank of Canada continues to be sooner rather than later. While the labour market remains healthy, albeit trending in the wrong direction in the last few months, the lacklustre economic growth would support an easing of monetary conditions. This is in stark contrast to the United States where inflation appears sticky at the 3% level and economic growth is healthy. And also suggests that the BoC may be the first central bank out of the two to cut rates. This is likely to have a weakening effect on the loonie against the greenback as interest rates fall faster in Canada than the United States. Economic growth and inflation are not on the same path in Canada as in the United States, we shouldn’t expect our monetary policy to be on the same path either. We continue to believe the greater risk lies in a policy mistake should the BoC hesitate on rate cuts.

Leslie Preston, managing director and senior economist, TD Economics

February’s inflation report was a little bit of good news for Canadians. After stalling through the second half of last year, that is two months of improvement on the Bank of Canada’s key core inflation gauges. However, the battle isn’t won yet, and we now expect the Bank of Canada will leave the overnight rate unchanged until July, as outlined in our new forecast released today.

Matthieu Arseneau/Alexandra Ducharme, economists at National Bank Financial

The biggest surprise came from clothing prices, which experienced atypical weakness recording a 2.7% decline, the second sharpest contraction in history after the 6.7% decline recorded in April 2020 when the economy was closed at the start of the pandemic. There were, however, other weaknesses during the month - notably food, which posted its first monthly price fall since December 2020. Household operations and alcohol/tobacco were also showing price declines. This is the first time in 18 months that we have seen half of the major components in a deflationary situation. The Bank of Canada’s preferred core inflation measures also show general price weakness, with monthly increases of just one-tenth in February (matching their January prints). Over three months, those measures are essentially back to the central bank’s target (CPI-median at 2.1%, CPI-trim at 2.3%), and we believe these measures overstate current inflationary pressures.

Today’s data reflect the cooling of the Canadian economy over the last six quarters, during which the monetary policy transmission took place. Given the economy’s lagged response to interest rates, which remain restrictive, inflationary pressures are set to ease further in the months ahead. The private sector has generated virtually no jobs since June last year, illustrating the weak appetite of corporations. ... As the Bank of Canada’s latest communications have focused on inflation resilience rather than signs of weak growth, there is a risk that it will inflict too much damage on the economy by maintaining an overly restrictive monetary policy.

Claire Fan, economist, Royal Bank of Canada

Building on the January CPI report that was already showing broad-based easing in price pressures in Canada, the February report today reaffirmed those trends. Different measures of core inflation all decelerated and the diffusion index that measures the scope of inflation pressures also improved. That measure however was still showing slightly broader price pressures than pre-pandemic “norms”, suggesting there’s still room for more improvement. Overall, we continue to expect a persistently soft economic backdrop to further slow inflation readings in Canada in the months ahead, allowing for the BoC to start lowering interest rates around mid-year.

Charles St-Arnaud, chief economist, Alberta Central

Most importantly, the momentum of BoC’s core measures was 2.2% on average. This is the first time since February 2021 that the momentum in the BoC’s core measure of inflation is below 2.5%. The slower inflation momentum suggests that the underlying inflation dynamic has slowed to a pace consistent with the BoC’s target.

The broad easing in inflationary pressures in February will provide some relief for the BoC. However ... the BoC is unlikely to consider cutting rates until the momentum measure for the preferred core measure returns sustainably well below 3%, meaning that its preferred measures of core inflation are below 3% and that their momentum is around or below 2.5%. This is because inflation expectations and perceived inflation remain elevated. While the first condition has been met, the second could be reached in April, supporting our view that the BoC will cut its policy rate at the June meeting.

Simon Harvey, head of forex analysis, and Nick Rees, forex market analyst, Monex Canada (a foreign exchange firm)

On the whole, February’s inflation report is highly constructive for the Bank, but unfortunately for them it lands just two weeks after they moved the goalposts for an interest rate cut, stressing the level and the breadth of inflation as opposed to the rate of change to guide markets towards June as the likeliest time to begin easing. But even on these measures we’re seeing continued progress. Thus, with inflation measures trending in the right direction, the economy continuing to produce below-potential growth, and the labour market back into better balance, the Bank runs the risk of maintaining an overly restrictive policy for too long should it fulfil its guidance and delay any easing until June. If this is the case, such a stance could see policymakers forced to play catch-up with the economy in the second half of this year and cut rates by more than 25 bps in a singular meeting.

While critics will argue that policymakers will need a third confirmatory inflation report before cutting rates, we think the Governing Council could renege on its March guidance and commence its easing cycle in April, should March’s labour force survey and the Bank’s Q1 surveys return favourable results. If this is correct, this would be a watershed moment for the Bank seeing as it has strived to improve its communications under Macklem’s tenure, but ultimately we think a reversal on its forward guidance is less damaging for the central bank, rather than inducing unnecessary economic pain because it can’t look beyond its priors.

While we think the Bank of Canada should cut rates in April, whether it does or not is still an open question. After all, the Bank has notoriously been too slow to react to turning points in the economy, producing two policy mistakes throughout its tightening cycle alone. For the Canadian dollar, whether the Bank cuts in April or delays until June effectively generates two scenarios; one in which we believe USDCAD could trend up to 1.38 in the short-term and another where the pair could breach 1.40 in the medium-term. By taking a more pragmatic approach and cutting in April, we suspect FX markets will respond unfavourably to the earlier sequencing of rate cuts in Canada, but this should be temporary and offset over the medium term by the positive growth impact and likely higher terminal rate. On the contrary, while a delay until June will help shelter the loonie against a more hawkish Federal Reserve in the short-term, we think such actions merely amplifies the economic pain inflicted on the Canadian economy and the risk the BoC will need to cut rates faster and to a lower terminal level than the Fed over the medium-term. Throw in the potential for a recession or prolonged stagnation in Canada against a backdrop of stronger US growth and higher Treasury yields, a world in which USDCAD trades back through 1.40 isn’t unimaginable should the BoC hold next month.

Bryan Yu, Chief Economist, Central 1 (credit union)

Today’s soft inflation report is a sufficient signal for the Bank of Canada that a cut to the policy rate should come sooner rather than later as the stalling economy eases price pressures. ... It was a good news story all around in February with the first back-to-back reading below three per cent since March 2021. ...

Shelter remained a counterweight to these easing price patterns with shelter accelerating to 6.5 per cent from 6.2 per cent on a 0.4 per cent m/m increase. Rent rose to an 8.2 per cent y/y increase, which was the highest since the early 1980s. Owned accommodation was steady at 6.7 per cent y/y amidst some easing in mortgage interest component (up 26.6 per cent) and easing replacement costs (-1.4 per cent). Shelter continues to feed into core measures of inflation but as we have noted, several factors are driving these costs. Higher interest rates have contributed to higher mortgage interest costs, while massive population growth continues to put upward pressure on rental accommodations. Excluding shelter costs, overall inflation is down to 1.3 per cent, and 1.9 per cent if we only exclude mortgage interest.

For the Bank of Canada, there remained much to ponder as it looks to timing of a rate cut but we think it should be soon. ... Shelter remains a challenge, but lower interest rates will further ease inflation and population driven demand (alongside supply constraints) are outside the Bank’s control, meaning it will need to look through this driver. While U.S. CPI trends are source of caution, we expect inflation to further ease as the economic slowdown continues and robust growth in labour supply constrains wage growth. A June cut remains mostly likely our view, but an April move is now back on the table.

David Doyle, head of economics at Macquarie

While an encouraging development that could lead to incrementally more dovish language from the BoC at its upcoming 10-April meeting, we still see hopes for an imminent rate cut as premature. Our base case remains that the BoC is only likely to cut rates commencing in July (25 bps). We see a cautious approach in 2024 with a total of 50 bps of cuts. In 2025, we foresee the BoC becoming more aggressive and cutting by a further 125 bps, which would reduce the Overnight rate to 3.25%. Risks to this are tilted towards more aggressive easing earlier with the potential for more than 50 bps of cuts in 2024.

We suspect the impulse from food and energy may pick-up near-term. An industry wide grocery price freeze ended in early February. Moreover, the retail gasoline price has continued to rise in 2024, although its impact has been blunted thus far by Statistics Canada’s seasonal adjustment process.

Vinayak Seshasayee, portfolio manager, and Graeme Westwood, economist, PIMCO

We anticipate the Bank of Canada will start reducing interest rates around mid year, as Canadian inflation slows toward its target. We estimate the underlying inflation trend to have fallen below the top end of the BOC’s 1%–3% inflation range by the end of 2023,and with economic growth stagnating in recent quarters, we believe further labor market easing will give the BOC the confidence to begin easing by midyear. ...

Although the market is pricing a similar trajectory of rate cuts for the BOC and the Federal Reserve, Canada’s economy has been weaker. We think the pace of easing is likely to proceed more quickly than in the U.S. owing to three factors that are weakening the economy: faster mortgage renewals, a slowdown in immigration, and weaker labor market dynamics.

The key takeaway from our assessment is that when easing starts, it could be more forceful and rapid in Canada than the U.S. We favor an overweight to two-year bonds in Canada, relative to both similar-maturity bonds in the U.S. and longer-dated Canadian bonds, which trade well below the overnight rate.

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