Bank of Canada’s outlook: Rate cuts to kick-start a recovery

The second half of the year will mark the beginning of a less restrictive monetary policy in Canada.

With inflation declining toward its target, we forecast a gradual rate-cut cycle, and it has already started with the 25 basis-point reduction in June. We see a total of four rate cuts this year, 25 basis points each, which would leave the central bank’s policy rate at 4 per cent.

The cuts will pave the way for greater business investment and consumer spending, easing what has been a subdued growth outlook for Canada’s economy.

We see Canada ending the year at 1.0 per cent growth, slightly lower than the 1.1 per cent of last year, before accelerating next year. Gross domestic product should come in at 0.8 per cent for the second quarter, followed by 1.2 per cent in the third quarter and 1.9 per cent in the fourth.

In Canada, growth has been much more modest than in the United States as inflation has slowed. This widening gap has led to a divergence in the two central banks’ policies, with the Bank of Canada cutting rates before the Federal Reserve, and potentially resulting in a decrease in the value of the Canadian dollar. 

The Bank of Canada’s rate reductions this year will kick off a slow and gradual rate-cut cycle, with the terminal rate reaching 3 per cent, significantly higher than the ultralow interest rates over the past two decades.

The reasons for rate cuts are clear. To start, monetary policy has made remarkable progress in restoring price stability in Canada. For three months in a row, headline inflation has fallen below 3 per cent, and all measures of core inflation have also fallen to 3 per cent or below.

Shelter inflation remains the major barrier on the way back to 2 per cent. But since Canada’s housing inflation is a supply issue, not solely a monetary issue, the Bank of Canada needs to look beyond housing. Instead, the central bank should look at the consumer price index (CPI) excluding shelter and CPI excluding interest rates, both of which are well within the 1 per cent to 3 per cent range.

More disinflationary pressures are in the picture as the labour market cools and businesses keep prices competitive to adapt for consumers’ constraints.

More critically, the Canadian economy has stagnated, even with the help of immigration which has added hundreds of thousands of workers to the economy. Gross domestic product per capita has fallen, while the unemployment rate has been on the rise.

Keeping rates restrictive for too long would only hamper a recovery and increase the odds of a recession.

To be sure, monetary policy will remain restrictive even after the Bank of Canada cuts its policy rate. The lagging impact of previous rate hikes will continue to resonate. And since the nominal interest rate has stayed constant for nearly a year while inflation decreases, the real interest rate has increased measurably, causing businesses to put the brakes on spending.

On the positive side, there are tail winds for growth. First, businesses and consumers are showing growing optimism about rate cuts.

Second, immigration will continue to add to both consumer spending and the labour supply while limits on temporary residents, including international students and temporary workers, could ease the strain on housing and social services. In the longer term, the benefits of immigration to the Canadian economy, by adding to the labour supply and the consumer economy, must not be understated.

Challenges remain for the economy, though, including lagging productivity and an uncertain global geopolitical environment.

But as the easing of monetary policy permeates the economy, Canadians can expect a recovery to start in the second half of the year, with a return to more normal growth next year.