The Canadian and US economies are tightly integrated, and tend to provide similar data for their central banks to move together. That’s no longer the case, as Canada’s economy grinds to a halt and inflation spirals back towards target. Meanwhile, the US economy continues to outperform expectations. Will economic divergence result in diverging monetary policy? At least one bank sees the Bank of Canada (BoC) cutting rates before the US Federal Reserve, as the two countries head on different paths. However, the market isn’t ready to commit to this call… yet.
Canadian Inflation Surprise May Drive Lower Fixed Rates
Canadian inflation came in much cooler than expected, helping to drive yields lower. Headline inflation was just 2.9% in January, trimming nearly half a point in a month. The BoC-preferred Core CPI, considered more stable than headline, even dropped 0.3 points over the month. The latter remains above an acceptable target range, but it’s heading in the right direction.
The decline is largely attributed to weak demand, the opposite issue seen in the US. American headline CPI remains at 3.9%, significantly above the Federal Reserve’s target rate. The country’s economy is heading in the opposite direction, leading to a divergence—at least into the short-term.
Cheaper Mortgages In Canada, More Expensive In The US
Canada is a relatively small economy and the US is its biggest trade partner. Consequently, the two countries tend to have economies that are tied very closely, including monetary policy. In fact, the BoC explicitly demonstrates this by using the US neutral policy rate as its own.
However, the market currently views the two countries heading in the opposite direction. “Canadian bond markets managed to buck the upward trend in yields this week, courtesy of a surprisingly friendly CPI reading,” wrote Douglas Porter, Chief Economist at BMO.
Porter’s observation indicates Canadian fixed rate mortgage interest costs are seeing pressure ease. Unlike in the US, where mortgage rates are heading in the opposite direction on the strength of its economy.
A divergence like this leads to the unusual consideration of what occurs when two tightly-linked economies move in the opposite direction.
“These diverging trends add to an ongoing debate since the possibility of rate cuts first came into view: Who would cut first, the Bank of Canada or the Fed?” rhetorically asks Porter.
Answering his own question, he continues “We have consistently leaned to the former, given the greater strain on the domestic economy from high rates, and a slightly cooler inflation backdrop. And the latest round of data supports that view, on both growth and inflation.”
Though Porter’s team is fairly certain, he explains the market isn’t fully sold on this idea. He estimates the market is pricing in 50-50 odds for a BoC rate cut in June.
“The lingering concern about early rate cuts in Canada is not so much about stoking a flaming equity market—no Nvidias in the TSX, sadly—but instead about fanning a simmering housing market,” he says.
House prices should not be the thing driving monetary policy in Canada. We have a housing problem–not enough housing–and that demand is going to drive prices regardless. If speculation in the housing market is the problem there are policy solutions for that, as we have seen in BC. Flip a house in under 24 months, pay a tax.
But artificially high interest rates do nothing to help housing supply as it makes it more expensive to build. The time from breaking ground to final sale has to be financed, and that cost becomes part of the cost of building the house. Higher interest rates are actually like a “tax” on housing activity–there is less of it and it is more expensive!
And high interest rates have been shown to actually be a driver of inflation–we see that now in higher mortgage costs factoring into the calculation of the inflation rate but higher rates also transfer well to those who hold assets.
Monetary policy is a hammer when what is needed is a scalpel. It is time to stop hitting ourselves over the head!
Double whammy to push USD to CAD exchange rates. Inflation creating a head fake in the US while Canada is coming down to 2% mark.
Which creates inflation once CAD to USD goes down into the 60s if BoC lowers to keep economy out of recession.
Alternatively, BoC will throw HB under the bus and follow the US FED to keep CAD/USD around 70ish cents.
The case for dropping the overnight rate is even stronger than Doug depicts it, since the only core inflation measure he looks at besides the current operational guide, or rather the approved two thirds of it, is CPIXFE (3.1%) which is still above the 3.0% upper bound, and which has never been the Bank of Canada’s operational guide. He didn’t report on CPIX (2.4%), the former operational guide, which excludes mortgage interest cost, or CPIXFET (2.6%), our first operational guide, both of which are much under the 3.0% upper bound, CPIX being closer to the 2.0% target rate than the upper bound. It would be hard, nay close to impossible, to argue that CPIXFE is a better core measure than CPIXFET. Doug makes his choice based on the CPIXFE being available a day ahead of the CPIXFET, when the other CPI measures are released, and he can’t be bothered to start referring to the CPIXFET later on, even when it differs so dramatically from the CPIXFE in its inflation rate as it does in January 2024. But I digress.
The English economist Shaun Richards hypothesized that the Bank of Canada was just trying to raise or lower rates when the US Fed did, a task made more complicated because its interest rate announcements precede those of the Fed by a number of days. If this is the case, than the Bank of Canada lowering its rates before the US Fed does would be no big deal, if it correctly believed that the US Fed would lower its rates at the next interest rate announcement data. Even if the US Fed didn’t do so, it might merely mean that our central bank had guessed wrong, but, since the direction of travel looks pretty clear, it would just wait on the Fed’s next announcement, which likely would be a rate cut. For very much worse, the Bank of Canada seems to have bought into the US Fed’s policies, even its dysfunctional average-inflation targeting framework, which caused such a disastrous runup in inflation in 2022. It would be nice if it clearly signaled that it was going to follow an independent policy. It hasn’t done so to date, and it hasn’t really been put under any pressure by external so-called experts to do so.