October 25, 2023 | 10:44
BoC: Pause Patrol
The Bank of Canada kept its key overnight lending rate unchanged today at 5.0% as widely expected, the second consecutive meeting on hold. Whether this translates into a more extended pause or not will depend critically on whether the economy has cooled enough to bring underlying inflation even lower in the coming months. Judging by the Bank's tone today, they remain unconvinced. While pointing to the many signs of cooler demand and some relief on price pressures, the final paragraph of the Statement notes in conclusion that "inflation risks have increased". Not wanting to repeat the misfire earlier this year, the Bank then flatly states that it "is prepared to raise the policy rate further if needed." Zero ambiguity around the bias there.
The Bank also released its quarterly Monetary Policy Report (MPR) today, replete with a fresh set of economic forecasts. The main point there is that the GDP growth estimates for this year and next have been carved down to size, partly due to downward revisions to earlier quarters, but also because of the dampening impact of the rapidly rising rate environment. They are now mostly in sync with our call, albeit a tad higher for this quarter and next (see the table below), looking for roughly 1% GDP growth on average for this year and next, before a return to 2.5% in 2025. Unfortunately, the inflation forecast has traveled in the opposite direction (mostly, but not entirely, due to energy prices), with the Bank now expecting inflation to average 3.0% next year, a meaty half-point higher than the July call and even above our above-consensus view. (Note, over the past three years, the Bank has never had a higher inflation call than us.)
Some key quotes: "There is growing evidence that past interest rate increases are dampening economic activity and relieving price pressures." And... "Overall, a range of indicators suggest that supply and demand in the economy are now approaching balance." The recent run of soft GDP growth has left the output gap close to balance (a range of -0.75% to +0.25%), a clear sign that underlying inflation pressures should soon relent. However ...
"Near-term inflation expectations and corporate pricing behaviour are normalizing only gradually, and wages are still growing around 4% to 5%. The Bank’s preferred measures of core inflation show little downward momentum." The Bank is clearly frustrated by the achingly slow (but entirely predictable) descent in inflation. In fact, we would note that the huge drop in inflation in the past 15 months—from 8% to less than 4%—is the largest such drop in inflation absent a recession in the past 70 years.
Finally, the Bank also looks again at the impact of a rapidly growing population: "The surge in Canada’s population is easing labour market pressures in some sectors while adding to housing demand and consumption. In the labour market, recent job gains have been below labour force growth and job vacancies have continued to ease." Moreover, the MPR makes plenty of nods at per capita measures, as the Bank clearly does not want to get lulled into reading too much into headline gains that are being flattered by 3% population growth.
Bottom Line: We have long believed that 5% rates are plenty high enough to eventually quell underlying inflation, but it will take time and patience. Strong wage growth and firm core inflation trends are going to test the Bank's patience. However, all signs suggest that the economy is struggling mightily to grow—despite the artificial sweetener of a surging population—with Q3 GDP about flat, housing halting, consumer confidence crumbling, and the Business Outlook Survey pointing south. Still, price and wage growth remain too fast for the BoC to back off its hawkish rhetoric just yet. To act on that hawk talk would take either a big rebound in growth, a renewed acceleration in inflation, or perhaps a considerably weaker Canadian dollar. We assume none of those forces will weigh in, and look for the Bank to remain on hold deep into 2024.