Will the Bank of Canada find itself left behind once again?

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In January 2022, conditions were ripe to start raising interest rates.

The annual pace of inflation had reached 4.8 percent the previous month, more than double the Bank of Canada’s target. After minimizing the risk of inflation until 2021, central bankers were starting to sweat. It was high time to start tightening monetary policy.

Yet when the rate decision came on January 26, the Bank of Canada reversed course. Instead of raising interest rates, where they had been since the early months of the pandemic, Governor Tiff Macklem used the rate decision to fix the problems and signal that a rate hike would take place during the next meeting in five weeks. time.

This story could be instructive as the Bank of Canada approaches another turning point.

Next Wednesday, June 5, Mr. Macklem and his team will have their first real opportunity since the start of rate hikes in 2022 to begin easing monetary policy.

Inflation has returned to the bank’s target range for four months, while high interest rates continue to weigh on households and businesses. The latest GDP data, released on Friday, came in weaker than expected and showed a deceleration in the economy in the first quarter.

Overall, recent data suggests it is time for the central bank to reverse course and start cutting rates before plunging the economy into an unnecessary recession and overshooting its 2 percent inflation target. hundred.

But there are arguments in favor of a status quo until July, which could influence a group of wary central bankers, marked by the experience of losing control of inflation, which reached 8.1% in mid-2022.

The Canadian real estate market is dynamic, and home prices could take off as interest rates begin to fall. That’s something Mr. Macklem and the bank’s five deputy governors may want to delay until the spring home-buying season is well over.

Likewise, the Bank of Canada cannot get ahead of the U.S. Federal Reserve, which is not expected to begin cutting interest rates until September at the earliest, without putting downward pressure on the Canadian exchange rate.

Then there are the intangibles. Central bankers are a conservative group that generally prefers to act methodically and signal changes in advance, as they did in early 2022. Faced with the choice between waiting too long and crushing the economy more than necessary, or scaling back too early and risk a rebound in the economy. When it comes to inflation, the BoC board may be inclined to choose the former – especially after their credibility has been tarnished by several years of uncontrolled price increases.

“There’s no right answer as to when you should cut. Central bankers make judgments based on a set of data, and unless you’re in the room, you don’t know precisely what will tip the scales. towards one decision or another,” Frances Donald, chief economist at Manulife Financial, said in an interview.

“In normal times, the Bank of Canada would probably have the green light to start cutting spending now and quite significantly. But they will be haunted by the fact that a mistake of cutting spending too early or too quickly would be extremely costly for Canadians, who have already suffered a significant inflationary shock,” she said.

Adding it all up, financial markets are moving toward a quarter-point rate cut next week, with interest rate swap traders estimating the probability at around 80 percent after Friday’s GDP data .

It would be a historic turning point after the biggest inflationary shock since the 1980s and one of the most aggressive monetary tightening campaigns on record, which saw the Bank of Canada raise rates 10 times between March 2022 and July 2023.

Based on the data alone, it becomes difficult to argue that the bank’s policy rate should still be at 5 percent, a two-decade high reached last summer. Simply put, inflation looks pretty good, while the economy looks pretty bad.

Annual consumer price index (CPI) inflation jumped in 2021 and 2022 due to supply chain issues, commodity price shocks and strong consumer demand, fueled by low interest rates and generous government support during the pandemic.

Since peaking in June 2022, price increases have eased as global drivers of inflation faded and high interest rates dampened domestic demand. Earlier this year, headline CPI inflation had returned to the Bank of Canada’s target range of 1 to 3 percent, reaching 2.7 percent in April.

Core inflation measures are now below 3 percent. And although housing inflation remains at a worrying level, if we exclude mortgage interest costs, which are under the control of the Bank of Canada, inflation is already below the target of 2 percent.

Meanwhile, the Canadian economy is stumbling. Unemployment increased by a percentage point over the past year and business bankruptcies increased. The economy as a whole has been operating below its potential for several quarters.

“Those are really the three main things that the Bank of Canada looks at: inflation, the labor market and overall growth. And they’re all heading in the same direction. So I like the call for them to start proceedings next week,” Doug Porter, chief economist at the Bank of Montreal, said in an interview.

However, that’s not a sure thing, Porter said. The economy has not fallen into a full-blown recession and indicators of financial stress, such as mortgage delinquencies, are not flashing red. This gives the bank some leeway if it wants to buy time and look at two more inflation reports.

Mr. Macklem and his team also have to think about the U.S. Federal Reserve, which is facing a stronger economy and more stubborn inflation.

“It’s a difficult decision to make and of course what makes the decision even more difficult is the fact that the prospects for interest rate cuts in the United States continue to get further and further away,” he said. Mr. Porter said. “If this was just a national issue, I don’t think it would be such a difficult decision.” I think the bank would be strongly inclined to start the process now.

Manulife’s Donald said concerns about differences between the Bank of Canada and the Fed could actually, counterintuitively, argue for a rate cut next week. Waiting longer increases the risk of recession, she said. And that would mean further cuts from the Bank of Canada in the future and a wider gap between the two countries’ monetary policies.

The challenge for the Bank of Canada, whatever path it chooses, will be managing expectations. A quarter-point rate cut won’t suddenly make housing affordable again, and people renewing their mortgages over the next two years are still at risk of a major payment shock, whether the central bank acts next week or in the middle of the period. summer.

Mr. Macklem has repeatedly said in recent months that interest rates will not fall as quickly as they rise and that borrowing costs will likely stabilize at a higher level than Canadians have been accustomed to over the past few years. of the decade between the 2008 financial crisis and COVID-19. 19 pandemic.

“I think there are good reasons why they choose to attend every other meeting, so you have 12 weeks, which gives you two inflation reports and two employment reports,” said Beata Caranci, chief economist at the Toronto-Dominion Bank, in an interview.

“I still believe the most we will get this year will be 75 basis points. So their starting point doesn’t change the cumulative amount I would expect. (There are 100 basis points in a percentage point.)

A similar story is playing out all over the world. Having raised interest rates roughly in lockstep, most central banks in advanced economies are preparing to pivot.

The Swiss National Bank and the Swedish Riksbank have already started easing rates, and the European Central Bank is expected to announce its first rate cut on Thursday, the day after the Bank of Canada’s decision. Financial markets expect other central banks in advanced economies to follow suit over the summer, with the exception of the Fed and the Bank of Japan.

High interest rates have hit some countries harder than others. But most have avoided major recessions, achieving a “soft landing” that few economists believed possible given the scale of the inflation problem and the barrage of interest rate hikes.

“It’s too early to bring out the bottles of champagne. We’re not there yet, especially in the United States,” Mr. Porter said. “But it appears they have struck the right balance, weakening the economy just enough to bring inflation down without tipping it over the edge.” And we weren’t sure they could do it.