A case for the Bank of Canada to accelerate rate cuts

With restrictive financial conditions, high interest rates and still-elevated inflation, the Canadian economy has reached a standstill and is now at a tipping point.

The Bank of Canada’s decisions over the next few months could influence whether the economy arrives with a soft landing or falls into a recession.

The central bank is tasked with the challenge of achieving price stability while the economy weakens. Cutting rates too early could risk reigniting inflation, and conversely, waiting too long risks an unnecessarily long and deep economic downturn.

Many indicators suggest that the Bank of Canada might start its rate cuts in June, with a 25 basis-point reduction. But that risks a delay that could needlessly tip the economy into recession.

In our view, the central bank should start the cuts in April. We also expect a minimum of four 25 basis-point cuts this year to bring the rate down to 4 per cent.

The Bank of Canada has been clear that it will not begin cutting rates until it has enough evidence that inflation is under control. Now, that evidence is mounting. The economic slowdown at home and abroad indicates it will soon be time for the central bank to take its foot off the brakes.

Two years ago, the Bank of Canada led the G-7 in one of history’s fastest rate hike cycles. And now it is time for them to lead again, this time in rate cuts.

The last mile to price stability

It took a year for inflation to fall from 8 per cent to 3 per cent, yet more recently inflation has barely budged, illustrating the difficulty in getting inflation down to the central bank’s target of 2 per cent.

But disinflationary forces are growing. Monetary policy stomped out excess demand and has tipped the economy into excess supply. Higher rates mean higher mortgage payments, which prompts households to cut spending. As consumer demand wanes, businesses cannot keep raising prices.

The job market is slowly tilting into an employers’ market, which could soon dampen wage growth.

Core inflation will most likely continue to decline, albeit slowly, as the impact of previous rate hikes permeates the economy.

A global economic slowdown will keep prices of goods, including gasoline and energy, in check, leading to disinflation in the spring and summer. 

The biggest challenge in taming inflation remains in housing. Excluding shelter, inflation had fallen to 2.4 per cent by this past December. Excluding mortgage interest payments, this figure is 2.5 per cent.

Shelter inflation stems from two main factors: high rent growth because of the housing shortage and increasing mortgage interest payments because of higher interest rates.

The Bank of Canada cannot fix the former. The chronic housing shortage will take years to address from all levels of government and businesses.

Monetary policy directly contributes to the latter. When homeowners renew their mortgages, their payments increase because of higher rates.

Even after the Bank of Canada begins cutting interest rates, monetary policy will remain restrictive, and the policy rate will far exceed the average rate of the past 20 years. Since it takes 18 to 24 months for the full impact of rate changes to take hold, last year’s rate hikes will continue to dissipate inflationary pressures across the economy.

Cutting rates to aid recovery

While Canada will likely not see 2 per cent inflation until next year, the central bank does not have to wait until then to drop the policy rate.

The macroeconomic environment in Canada is looking considerably weaker than in the United States. Businesses and consumers in Canada have higher debt levels and are more rate-sensitive.

The RSM Canada Financial Conditions Index, which measures risk priced into financial assets, remains negative because of increased risk and volatility in the bond market and the decline in commodity prices.

The Bank of Canada’s Senior Loan Officer Survey results confirm that these excess risks are because of tight lending conditions.

For the past few months, consumer spending per capita has declined, the number of hours worked has dropped and the unemployment rate has been creeping up.

In December, Canada lost 23,500 full-time positions while adding 23,600 part-time positions. While the overall jobs increased, the truth is that labour demand has decreased.

Households have pulled back spending to afford their higher mortgage payments. Businesses are delaying hiring and investments.

The real interest rate already stands at 2 per cent and will rise as the nominal policy rate stays constant and inflation eases.

It will take time for investments and spending to recover, but a rate cut in early spring might give the economy the extra push it needs to get over the hump and revive in the second half of this year.

Risks remain

Inflationary risks have not gone away. Shelter inflation will most likely be a pain point not only now but in the upcoming years as the housing supply fails to keep up with demand.  

Wage growth is still in the 4 per cent to 5 per cent range, which means that prices of services will take time to decelerate. But cooling labour demand means lower wage growth might be on the horizon. 

There is also risk in the exchange rate. The Bank of Canada and the Federal Reserve have largely synchronized their policies, and the Fed expects to begin its first rate cut in June.

A cut by the Bank of Canada before the Federal Reserve could lead to the Canadian dollar losing value in the short term, making goods more expensive for Canadian businesses and consumers, which means increases in inflation. But the impact will be temporary as another bump in the road. The Canadian dollar would gain some value by the end of the year, which would help ease inflation into the mid-2 per cent territory.

The takeaway

This year, the Bank of Canada’s trajectory will gradually moderate its policy rate, absent another major shock.

The first half of the year will be challenging for businesses and consumers with high interest rates and will bring muted growth. But an earlier start to the rate cuts could allow the economy to revive in the second half, as long as inflation stays under control.