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Canada Likely to See Rate Cuts Before U.S.

November 21, 2023 9 min 37 sec
Avery Shenfeld
CIBC Asset Management
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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Avery Shenfeld, chief economist at CIBC.

I think many of us welcomed the Bank of Canada’s decision to leave rates on hold at its latest meeting. It’s clear that inflation is not where they want it to be, but the economy has clearly also gone into a stall in growth. We’ve had very little growth really over the last six months or so, and that should over time take care of the inflation issues, so they want to avoid overdoing it.

You have the governor saying that he doesn’t see the need for an outright recession to get inflation under control. And since we’re now in a period, basically we’re as close to recession as we can be with virtually zero growth for a while, I think it behooves the Bank of Canada to now sit back, wait for those, that slower growth to open up some slack in the economy and bring inflation back to target.

The Bank of Canada is driving a car where you have to turn the steering wheel several blocks ahead of where you want the car to turn, in the sense that they raise interest rates today, or in the past year and they don’t see the full impact on the economy for a few quarters. And the impact on inflation actually lags a bit behind that because you need to run a slow economy for a while for the unemployment rate to drift up, for wage and price inflation to start to decelerate. And so I don’t expect the Bank of Canada to move on interest rates as long as we continue to see this soft patch for growth, as long as there are signs of slack opening up in the economy, that should leave them confident that with enough patience, lower inflation, that is, will follow.

The bar to start cutting interest rates as opposed to merely leaving them on hold is quite a bit higher. The Bank of Canada would first of all have to see some signs of greater slack in the labour market. The bank points to the tightness in the labour market as a clear impediment to getting wage and price inflation under control. So we’ll need to see a somewhat higher unemployment rate, likely a bit above 6% for a while. And some signs that wage inflation is starting to slow before they would cut interest rates. And they might even need to see some actual progress in getting core measures of inflation down.

I don’t think they’ll need to see headline inflation all the way back at 2% because perversely, one of the things that’s going to stand in the way of that is that the inflation measure includes mortgage interest costs and high mortgage rates are actually adding to that particular component of inflation. But they’ll be looking at other metrics of inflation that strip out some of that impact of higher mortgage rates and they’ll need to see some progress in other measures of inflation coming at least closer in line with the 2% target before they cut.

It does look like the high inflation numbers that we saw a year or so ago are now firmly behind us, and that’s not really just a Canadian story. We’ve seen inflation peak and come down in the U.S., in many European countries, and part of that is not really that the central banks raising interest rates caused that. It’s that some of the earlier inflation was tied up with supply chain difficulties, emanating initially from the Covid pandemic and workers being absent, Chinese factories being shut down. And then also the war in Ukraine that initially caused a surge in oil prices and world grain prices. And what we’ve seen is broadly speaking across the good sector of the economy, that inflation has melted away as factories returned back to normal production schedules as Russian oil didn’t in fact get cut off from the world the way it was feared after the start of the war in Ukraine. And even Ukraine managed of course to ship more of its grain to global markets as well.

So that’s brought inflation down everywhere in the world. The problem is that the last mile of this journey to lower inflation is really the one where we need to go through a period of slower economic growth globally in order to bring down things like services, prices, and other parts of the inflation story that remain still above the kind of temperature readings that the central banks are looking for.

The fact that central banks around the world, not only in the U.S. but in Europe and Australia, have collectively been raising interest rates, all of course for the same reasons as the Bank of Canada in an effort to slow growth and contain inflation in their countries. Those interest rate hikes are in fact a helpful hand for the Bank of Canada in its task to slow the Canadian economy. For one, on the inflation front, it has helped cool the temperature of some commodities, things like energy prices, that feed into Canada’s CPI. Slower global growth will do that. But it also means that the market for Canada’s exports is also slowing, helping to moderate growth and therefore inflation pressures in Canada.

We’ve seen European growth slow to a slow crawl and perhaps even some recessions in some parts of Europe. The U.S. of course, is one exception, their economy really hasn’t slowed in 2023. But the Bank of Canada can take comfort that with interest rates as high as they are now in the U.S., they can look ahead to a slowing in that economy and therefore a cooling in the market for Canada’s exports south of the border. So all told, higher interest rates in the rest of the world have perhaps taken a bit of the pressure off the Bank of Canada to continue to raise interest rates here and cool the domestic economy because our export prospects are slowing and that should help us on the inflation front.

We’re now in a watchful waiting mode, like the Bank of Canada, like the Federal Reserve, and we’re looking for two key developments. One is that in Canada we don’t really need a further slowdown. The one we’ve already got would seem to be sufficient to do the job, to take the steam out of inflation. So we’re mostly watching to see how that slowdown translates into a cooler labour market, into a cooling in wage pressures, and down the road some softer core inflation readings. In the U.S. it’s a bit more of a mystery at this point why the U.S. economy has yet to respond very much at all to higher interest rates. So really we’re waiting to see that some of the sectors that have slowed, including housing and the resale market and the slowing that we’re seeing in corporate lending in the U.S., that those do translate into a broader slowdown in the American economy to put the Federal Reserve on hold as well, and then take the wind out of U.S. inflation.

So less concern here now about Canada, it does appear that our economy is slow enough to get our inflation problem behind us at some point. And we’re hoping to see a moderation in U.S. growth, not an outright recession, but a slowing sufficient so that we gain comfort that U.S. inflation will also come down in 2024.

We expect the U.S. to lag behind Canada in terms of when it ultimately starts cutting rates. In fact, there’s still a risk that the Federal Reserve will hike another time given the fact that the U.S. economy hasn’t materially slowed yet in the face of interest rate hikes that have been similar to Canada’s but haven’t slowed the consumer sector in particular. And the fact that the U.S. economy is weathering the storm of high interest rates much better in Canada also leads us to a view that it will take longer then for high interest rates to produce enough downward pressure on American inflation for the Federal Reserve to join the Bank of Canada in easing interest rates in 2024.

We do expect to see some rate cuts in the second half of next year in the U.S., but probably starting a quarter or so later than where we would see the Bank of Canada moving, which would be sometime in the second quarter. And likely fewer interest rate cuts, that is a shallower path to lower rates in the U.S.

Simply put, the American household sector is not as sensitive to higher interest rates as the Canadian household sector. They’re not as indebted. Their mortgages are locked in for 30 years. And so the American economy won’t be as early in needing some relief from lower interest rates as the Canadian economy is likely to be.