Cooling inflation, here and south of the border, and a weakening economy have turned markets’ attention from rate hikes to rate cuts.
Investors are now fully pricing in a 25 bps rate cut by April, a 75 per cent chance by March and even a 20 per cent chance by next week.
Stephen Brown, deputy chief North American economist for Capital Economics, thinks odds of a cut as early as next week are way off the mark, but also believes markets are underestimating the degree of policy loosening to come in 2024.
Capital expects the Bank will tone down or even drop its tightening bias next week because of developments since its last meeting in October.
Oil prices, a big driver of inflation, have fallen back after a spike over the Israel-Hamas war to below what the Bank forecast in its October monetary policy report. Gas prices are at their lowest since March.
Capital now expects that headline inflation will average 3.1 per cent this quarter compared to the Bank’s forecast of 3.3 per cent.
The economy is also looking weaker than the Bank expected, said Brown. Gross domestic product data out today showed the economy in the third quarter shrank at a 1.1 per cent annualized pace, weaker than the Bank’s forecast of 0.8 per cent.
Other indicators support this. “According to the CFIB Business Barometer, the share of firms suffering from insufficient domestic demand jumped to 44 per cent in October, which implies that GDP is close to 1.5 per cent below its potential,” said Brown.
He also expects that jobs data out tomorrow will show a small rise in unemployment and slowing wage growth, “which should help to soothe the Bank’s lingering fears about wage pressures.”
Despite some tough talk on inflation, Bank of Canada governor Tiff Macklem “has now dangled the prospect of rate cuts a few times,” said Brown.
The governor repeated last week that cuts can begin before inflation falls to the 2 per cent target as long as there is a clear trend that it is headed that way.
Capital estimates that the Bank will need to see this trend for almost six months, making March or April the most likely meetings for cuts to begin.
But while markets expect only 95 bps of cuts over 2024, Capital believes the Bank will need to cut more than twice as much.
“The main reason we disagree with market pricing is that, based on our inflation forecasts, 100 bp of cuts would not be enough to prevent the real stance of policy from becoming more restrictive,” said Brown.
“In other words, the Bank will need to deliver 200 bp of cuts just to prevent monetary policy weighing even further on economic growth.”
One sticking point could be the housing market. While home prices are coming down, the Bank may take a more cautious approach to avoid fuelling another rally.
Yet, the sales-to-new listing ratio recently fell to its lowest since 2013, meaning that home prices could drop even more than the 5 per cent Capital is predicting by March.
“At a time when house price declines are gathering pace, … right now one can just as easily make the opposite argument that the Bank will need to act aggressively to prevent the housing market from falling into a tailspin,” he said.
Consumer credit has slowed to its slowest pace in 30 years, and when adjusted for inflation National Bank economists estimate that it has actually fallen by 1 per cent. The last time household credit fell in Canada it was the great recession of the 1990s, which the prime rate hit 14 per cent and the jobless rate was 12 per cent, said National economist Stéfane Marion.
“There is simply no precedent for a contraction in household credit of the current magnitude, while the unemployment rate remains below 6 per cent,” wrote Marion.
“Let’s hope that the next employment report on Friday doesn’t show too much of a deterioration in hiring, otherwise the credit cycle will continue to deteriorate.”