The Bank of Canada “unpauses”—what’s next?

The central bank meets again on July 12^th, and unless some data or event surprises, we can’t rule out another rate hike. Going forward, it’s likely the BoC will still have concerns that “CPI inflation could get stuck materially above the 2% target” and that “monetary policy [is] not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target.”

Given the time it takes for monetary policy changes to work their way through the economy and the fact that the policy rate already stands significantly above its neutral rate, the critical question, in our view, isn’t whether the Bank of Canada hikes one more time or not. Instead, we focus on three more powerful themes for the country’s economy in the coming year: 

• Global central banks are knowingly keeping rates high as we likely head into a recession.

We expect most major developed countries’ central banks, including the Bank of Canada, to continue hiking or keeping rates high through a good portion of the next economic downturn. The main reason is that there are still certain segments of excess demand in the economy, as this particular post-COVID cycle is desynchronized. For example, household consumption in Canada continues to defy reality, trending largely above where it should have been if it had simply followed its pre-COVID trends.

It’s also going to take some time for global inflation to come down, and even then, in level terms, we will continue to face higher price increases compared to pre-COVID. That will keep central banks much more hawkish relative to past recessions and raise the bar to rate cuts to the highest level we’ve seen since the 1970s. 

• Some Canadian consumers are already showing signs of distress, which are likely to worsen.

While Canada continues to add jobs and retail activity has been robust so far, we are concerned about the headwinds that Canadian consumers will face for the remainder of 2023 and going into 2024.

Over the past year, strong consumption has been driven by (on aggregate) excess savings, credit availability, and wage growth (though in real terms, wage growth has only turned positive for the past two months after almost two years of negative real income). When we look forward, however, this strength appears unsustainable. It’s clear the share of consumer income taken up by debt servicing—from mortgages to credit cards—is high and rising. In fact, consumer insolvencies have already begun to climb, a worrisome development. 

• Rate hikes won’t cure our inflation woes singlehandedly.

Problematically, the BoC is attempting to cure high inflation (its single mandate!) while high prices are being driven by a range of factors, many of which are not sensitive to domestic interest rates.

For example, food prices, which contribute almost a third to Canadian headline inflation today, are high globally and are function of conflicts, weather patterns and supply chain problems. Energy prices, which have recently helped lower headline Consumer Price Index (CPI) data, are volatile and at risk of rising again as OPEC+ countries have cut production in an effort to drive prices back up. We’re also aligned with the San Francisco Fed’s recent findings that labor cost growth is responsible for only a small percentage of recent core inflation (ex. housing) dynamics. This means that simply crushing labor demand by deterring business borrowing and consumer spending isn’t going to solve all of our inflation woes.

It's also worth highlighting that 0.8% of the 4.4% year-over-year CPI inflation is currently being driven by mortgage interest costs which are high because of the BoC’s previous rate hikes. Rent prices are also likely to remain elevated as the BoC makes access to the housing market less available while strong population growth continues to drive demand for housing. Yes, higher interest rates can crush certain elements of Canadian inflation such as services, and certain expensive durable goods, but we still expect headline inflation to remain somewhat elevated over the next 18 months despite higher interest rates (and a, in part, BoC-induced recession).

The important market call is not so much whether the BoC hikes again or not, but when the BoC begins cutting interest rates and also by how much. Our current forecast is that the BoC only begins reducing rates in early 2024, but that forecast is made more difficult by two conflicting forces. On one hand, Canada’s recession risk is deeper than the United States given substantially higher household debt levels. On the other, the wicked Canadian housing bubble is, implicitly, going to keep a tighter-for-longer bias within the BoC.

While the central bank might impact mortgage rates, it doesn’t control the supply environment in Canada (construction, zoning regulations, immigration targets, or how long it takes to get a building permit). Once again, we are unfairly asking the central bank to cure what ails Canada. Hikes or no hikes, housing has a structural bid under its surface that will be difficult for the BoC alone to remedy.

In the end, we expect the balance of these powers to shake out into cuts within the next 12 months even as the BoC is now focused on tightening. Cuts are especially likely if the U.S. weakens alongside Canada and the Federal Reserve also pivots. Regardless, this is a far cry from your standard recession-rate cut cycle, and economic forecasts need to take that into account.