Why the Bank of Canada could cut interest rates much more than markets expect.
The Bank of Canada is widely expected to hold its benchmark interest rate when it meets next week, but a lot has changed since October.
Cooling inflation, here and south of the border, and a weakening economy have turned markets’ attention from ratehikes to rate cuts.
Investors are now fully pricing in a 25-basis points rate cut by April, a 75 per cent chance by March, and even a 20 per cent chance by next week.
Stephen Brown, deputy chief North American economist for Capital Economics, thinks odds of a cut as early as nextweek are way off the mark, but also believes markets are underestimating the degree of policy loosening to come in 2024.
Capital expects the Bank will tone down or even drop its tightening bias next week because of developments since its last meeting in October.
Oil prices, a big driver of inflation, have fallen back after a spike over the Israel- Hamas war to below what the Bank forecast in its October monetary policy report. Gas prices are at their lowest since March.
Capital now expects that headline inflation will average 3.1 per cent this quarter compared to the Bank’s forecast of3.3 per cent.
The economy is also looking weaker than the Bank expected, said Brown. Gross domestic product data out todayshowed the economy in the third quarter shrank at a 1.1 per cent annualized pace, weaker than the Bank’s forecast of0.8 per cent.
He also expects that jobs data out tomorrow will show a small rise in unemployment and slowing wage growth,“which should help to soothe the Bank’s lingering fears about wage pressures.”
Despite some tough talk on inflation, Bank of Canada governor Tiff Macklem “has now dangled the prospect of rate cuts a few times,” said Brown.
The governor repeated last week that cuts can begin before inflation falls to the 2 percent target as long as there is a clear trend that it is headed that way.
Capital estimates that the Bank will need to see this trend for almost six months, making March or April the most likely meetings for cuts to begin.
But while markets expect only 95 basis points of cuts over 2024, Capital believes the Bank will need to cut more than twice as much.
One sticking point could be the housing market. While home prices are coming down, the Bank may take a morecautious approach to avoid fueling another rally.
Yet, the sales-to-new listing ratio recently fell to its lowest since 2013, meaning that home prices could drop evenmore than the 5 per cent Capital is predicting by March.
“At a time when house price declines are gathering pace, … right now one can just as easily make the opposite argument that the Bank will need to act aggressively to prevent the housing market from falling into a tailspin,” he said.
