Will the Bank of Canada Lag the U.S. Federal Reserve on Rate Cuts?

The U.S. Federal Reserve left its policy rate unchanged when it met last week, but its accompanying commentary has fuelled a consensus view that it will likely start lowering in the near future.

To wit, the U.S. futures market is now pricing in 100% odds of a 0.25% rate cut when the Fed next meets on July 31, and it is pricing in 68% odds that the Fed will lower its policy rate by 0.75% (or more) by the end of this year.

Here are five highlights from the Fed’s latest update:

1. The Fed noted that U.S. inflation continues to run below 2%. (It came in at 1.8% in May.) It removed its prior reference to the drop in core inflation being “transitory” and referred instead to “muted inflation pressures”. It also lowered its inflation forecast for 2019 from 1.8% to 1.5%.
2. The Fed offered a generally positive economic assessment in its official statement but observed that “uncertainties” in its outlook have increased of late. (U.S. Fed Chair Powell also used the term “uncertainty” six times during his press conference.) Trade tensions and slowing global growth were cited as the main causes of the Fed’s increased concern.
3. The Fed noted that “indicators of business fixed investment have been soft “. That is significant because business investment acts as a vote of confidence on the state of the economy, and rising business investment fuels employment and wage growth, which leads to increased consumer spending.
4. The Fed lowered its estimate of the neutral rate from 2.75% to 2.50%. As a reminder, the neutral rate is defined as the policy-rate level that neither stimulates nor slows economic growth. (Today the Fed funds rate stands at 2.25% to 2.50%, so the Fed is basically saying that its policy rate is now neutral.)
5. The Fed dropped its previous reference to being “patient” when making changes to its monetary policy and instead said that it would “act as appropriate to sustain the expansion”.

Increased concern about a sustained period of below-target inflation at a time when policy rates are still close to 0% is not just a U.S. phenomenon.

Inflation in the eurozone plunged to 1.2% last month, marking its lowest level in more than a year. European Central Bank (ECB) President Mario Draghi responded by expressing a willingness both to cut rates and to reintroduce quantitative easing programs if eurozone inflation doesn’t perk back up soon.

Against that backdrop, the latest Canadian inflation data present a stark, and somewhat puzzling, contrast.

Last Friday, we learned that our overall Consumer Price Index (CPI) rose from 2.0% in April to 2.4% in May on a year-over-year basis, marking our fifth straight monthly increase. Two of the Bank of Canada’s (BoC) three key measures of core inflation (which I describe in detail here) also rose, with CPI-trim increasing from 2.0% to 2.3% and CPI-median rising from 1.9% to 2.1%. Meanwhile, CPI-common, which the Bank of Canada (BoC) views as the best gauge of our economy’s underperformance, held steady at 1.8%.

Our recent inflationary uptrend presents a dilemma for the BoC.

On one hand, the Bank has repeatedly said that it will adhere to its primary mandate of preserving price stability even if doing so creates negative side effects for sectors of our economy. In the current context that means that the BoC should hold its policy rate steady for now and that it should even adopt more hawkish monetary-policy language if our current inflationary upswing continues.

On the other hand, if the Fed and other central banks start cutting rates and the BoC doesn’t follow, the Loonie will likely appreciate against other currencies. That will intensify an existing headwind for our export sector at a time when the Bank is counting on rising export sales to offset a slowdown in consumer spending.

So, what will the BoC do?

I think the Bank will lag the Fed’s first cut if it lowers by 0.25% on July 31. But if the Fed drops by 0.50% (as it did at the outset of its last two easing cycles) or if it drops by 0.75% by year end as the U.S. futures market now expects, I think the BoC will be forced to lower its policy rate by 0.25% at least once in 2019.

Here are five reasons why I say that:

1. The BoC operates with an inflation target of 2%, but it also uses a target range of between 1% to 3% to allow room for short-term fluctuations and anomalies, such as those we appear to be experiencing at the moment.
2. The Bank knows that inflation is falling in most of the world’s largest economies, and if this trend continues, our small, open economy will import that disinflation through trade.
3. Our economy is still absorbing the lagged impact of the BoC’s previous five recent 0.25% rate hikes, and by the BoC’s own timing estimate, that process won’t be complete until October 2020.
4. Our overall inflation rate has been below the Bank’s 2% target about 90% of the time since 2008, so it’s not as if our economy has been running hot for an extended period that would seriously threaten overall price stability.
5. If the current rise in inflation is unexpectedly sustained, our elevated debt levels make our economy more sensitive to rate hikes, and that will make it easier for the BoC to rein in inflationary pressures.

The Bottom Line: Last week’s Canadian inflation data poured cold water on recent speculation that the BoC might drop its overnight rate in the near future. That said, if the Fed starts aggressively cutting rates, that will raise the economic price of inaction by the BoC, and, for the reasons outlined above, I think the Bank will ultimately follow suit – at least to some extent. In the meantime, I doubt that last week’s surprising inflation data will materially impact Canadian mortgage rates over the near term.