"With interest rates no longer 'clearly in restrictive territory,' the central bank will take 'a more gradual approach' to monetary policy adjustments moving forward." – Claire Fan, RBC Economics
The Bank of Canada (BoC) has made its intentions clear: a softer landing is in sight. With its latest decision to cut the overnight rate by 50 basis points (bps) to 3.25%, the central bank has shifted gears, transitioning from aggressive reductions to a more measured pace of monetary easing. But as Claire Fan at RBC Economics outlines in her recent analysis, this approach is fraught with challenges, uncertainties, and the weight of a slowing economy.
The Cut That Sets the Tone
Today’s 50-bps reduction marks the second consecutive larger-than-usual rate cut, following the October decision. In total, the BoC has reduced rates by 175 bps since June, with this latest move bringing the overnight rate to the top end of its “neutral” range of 2.25%–3.25%. As Governor Macklem emphasized, “interest rates are no longer clearly in restrictive territory,” suggesting a pivot to smaller 25-bps reductions at future meetings.
Fan forecasts that this cautious trajectory will culminate in the overnight rate hitting a stimulative 2% by 2025, a level designed to counteract persistent economic softness.
The Softening Economy: Key Drivers
The BoC’s urgency to ease monetary policy stems from clear signs of economic slack. GDP growth has underperformed expectations for two consecutive quarters, and Canada’s unemployment rate has risen to 6.8% in November, up 2% since the labor market peaked in mid-2022.
Consumer spending and housing—typically the canaries in the coal mine for rate-sensitive sectors—are showing tentative signs of recovery. However, business investment remains sluggish, signaling that confidence in the broader economy hasn’t fully returned.
Fan warns that while rate cuts are intended to stimulate activity, their effects will materialize with a lag. “Interest rate cuts will continue to work to stimulate activities, especially the labor market, with a significant lag,” she notes, adding that the unemployment rate could edge up to 7% by early 2025 before stabilizing.
Uncertainties Cloud the Outlook
Despite its dovish pivot, the BoC’s path is riddled with complexities. Fan identifies several headwinds that could complicate the bank’s journey toward economic stability:
- Immigration Slowdown: For the first time on record, Canada’s population growth is projected to grind to a halt in 2025 and 2026 due to slowing immigration. While this will dampen both demand and supply, Fan notes that the BoC anticipates a “muted impact on inflation.”
- Trade Disruptions: Though mentioned as a “major new uncertainty,” details around potential trade disruptions remain vague. Given the global economic landscape, any upheaval could amplify downside risks.
- GST Tax Holiday: The upcoming temporary GST holiday from mid-December to mid-February will lower headline inflation mechanically, but it could paradoxically stoke underlying price pressures by boosting demand. To account for these distortions, the BoC has directed attention to core inflation measures (CPI-trim and CPI-median) as more reliable indicators.
Inflation’s New Reality
Fan’s analysis underscores the BoC’s delicate balancing act between stimulating growth and managing inflation expectations. “A soft domestic backdrop suggests the future path for inflation in Canada is still more likely lower rather than higher,” she explains. However, the unique pressures created by fiscal and trade uncertainties could complicate this narrative.
The BoC’s focus on core inflation metrics is a pragmatic move, especially during periods of temporary distortions. These indicators will help policymakers gauge the true trajectory of price pressures, offering a clearer lens through which to evaluate future rate decisions.
Key Takeaways
- Dovish Pivot: The BoC’s latest 50-bps rate cut reflects a transition to a more gradual approach, with smaller 25-bps reductions expected in 2025.
- Economic Weakness Persists: GDP growth remains subdued, and the unemployment rate is projected to rise to 7% before leveling off.
- Inflation Challenges: Temporary factors like the GST tax holiday and trade uncertainties complicate inflation readings, prompting the BoC to rely on core metrics for clarity.
- Structural Headwinds: Slowing immigration and potential trade disruptions loom large, adding layers of complexity to the BoC’s mandate.
- Stimulative Goal: RBC Economics anticipates that the overnight rate will reach a stimulative 2% by 2025, underscoring the central bank’s commitment to countering economic slack.
Conclusion: Navigating the Crosswinds
The BoC’s gradualism reflects its recognition of a fragile economy and the limits of monetary policy in addressing structural challenges. Fan’s assessment serves as a reminder of the intricacies involved in balancing growth, inflation, and broader uncertainties.
As Claire Fan aptly puts it, “Persistent softening in the economy into 2025 should ultimately motivate the Bank of Canada to cut rates down to stimulative territory.” For policymakers, businesses, and households alike, the coming months will test their resilience in the face of shifting economic dynamics.
Source: "RBC Royal Bank." 11 Dec. 2024, view.website.rbc.com/?
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