At-Target Inflation Shouldn’t Delay the Bank of Canada’s Own Mid-Cycle Adjustment

Today most of the developed world’s central banks worry about having too little inflation if they are lucky and outright deflation if they aren’t. (Central bankers worry about deflation, which is an outright decline in average prices, because their monetary policy tools are much better suited to tamp down inflation than to reignite it.)

Bond-market investors also see deflationary headwinds gathering, and that partly explains the recent breathtaking rise of global bonds with negative yields, which now total around $17 trillion (and counting).

Against that backdrop, the Bank of Canada (BoC) is in an enviable position.

Last week we learned that our overall Consumer Price Index (CPI) rose 2% in July on a year-over-year (y-o-y) basis. That result was right on the Bank’s target and considerably higher than the 1.7% result the consensus had expected. Furthermore, two of the Bank’s three key sub-measures of core inflation held steady at 2.1% y-o-y, and the other rose from 1.8% to 1.9% y-o-y.

When our overall CPI is at or above the BoC’s 2% target, it is noteworthy because we have spent about 90% of the time below that target since the start of the Great Recession in 2008.

Many market watchers have opined that our latest inflation data would prevent the Bank from cutting its policy rate at its next meeting on September 4. I’m still not convinced.

The BoC sets its monetary policy by focusing on the road ahead, where the skies are clearly darkening. On that note, here are five factors that support an insurance cut in two weeks’ time:

1. It is true that our economic data have recently been stronger than expected of late, but that has, in large part, been a function of comparisons to the extended weak period that has preceded it. Today’s improving momentum is a tentative recovery to be nurtured, not a robust surge to be reined in.
2. Our recent run has coincided with a significant rise in inventories (which looks like a sales increase on the surface but really just brings future demand forward). At some point this inventory overhang will have to be unwound, and as that happens, capacity pressures will ease.
3. In its latest Monetary Policy Report released on July 10, the Bank predicted that inflation will drop temporarily to 1.6% in the third quarter of this year. In the interim, new trends have conspired to put even more downward pressure on inflation: mortgage rates have dropped precipitously, oil and gas prices have fallen, and the Loonie has strengthened against most other currencies.
4. U.S. inflation peaked at only 2.9% last July when the U.S. economy was in the middle of a tax-cut-induced sugar high. It has fallen fairly steadily since and is once again back below 2%. In his recent testimony to the U.S. Congress, Federal Reserve Chair Jerome Powell highlighted the risk that “weak inflation will be even more persistent than we currently anticipate.” If the Fed is now openly worried about an extended period of too-low inflation, the BoC should share this worry because we will import softer U.S. inflation over time through trade.
5. We are now just about halfway through the total time it will take for the full impact of the BoC’s previous tightening cycle to be realized (as I wrote in a recent post). All else being equal, if the Bank just leaves its policy rate unchanged, our economy will be experiencing the effects of monetary-policy tightening well into next year. And this will happen against a weakening global economic backdrop – when more than 30 of the world’s other central banks have cut their policy rates thus far in 2019. (I’m all for contrarianism, but you can only swim against this kind of current for so long.)

If the BoC does decide to cut its policy rate, it can now do so with less concern about the stimulative impact it will have on house-price appreciation and mortgage-debt accumulation.

While a rate cut would lower borrowing costs for variable-rate borrowers, the Mortgage Qualifying Rate (MQR) that is used to qualify borrowers would likely remain unchanged (at 5.19%). That means the Bank’s rate cut would not expand actual housing affordability (or blow more air into already overinflated real-estate markets).

The BoC should follow the Fed’s lead and classify its next cut as a “mid-cycle adjustment,” at the very least to blunt the remaining unrealized impact of its previous rate-hike cycle. While there is a risk this move might stoke more inflationary pressure over the short term, the Bank’s 2% target operates with a broader target range of 1% to 3% specifically to allow for such short-term fluctuations.

Bluntly put, even if a cut leads to a little above-target inflation over the short term, that’s a problem many other central banks would happily welcome right about now. The Bottom Line: In a world where most central bank policy makers are worried about not having enough inflation, the BoC can well afford to make the insurance cut that current conditions call for. That’s why I continue to believe that it will drop its policy rate at its meeting on September 4. If I’m right, variable mortgage rates will finally move lower, and we might see another down leg in our fixed mortgage rates as well.