In an acknowledgment of the economy’s surprise contraction in the third quarter, the Bank of Canada on Wednesday shifted its tone on monetary policy from hawkish to neutral as it held its policy rate steady at 5 per cent.
A series of gradual rate cuts from the current 5% is in order starting in April and ending the year at 4%. We expect rate cuts of no greater than 25 basis points at a time as the central bank works to avoid restarting the inflationary cycle.
Canada’s economy has fundamentally changed in recent years as the workforce has aged and uncertainties have increased. As a result, the neutral rate of interest has most likely risen to 3%, and it will take the Bank of Canada until 2025 to get there.
Whether or not the economy enters a recession next year, policymakers are facing the prospect of anemic growth as rising interest rates take their toll on excess demand.
All economic indicators point to a weak outlook: The unemployment rate has increased as population growth outpaces job gains, consumer demand has plateaued, and inflation has softened as rising interest rates have taken effect.
Price pressures will continue to ease with weakening consumer demand, even for services. Headline inflation should fall into the 1 per cent to 3 per cent range, and core inflation will also continue to decline, albeit slowly.
The Bank of Canada signaled that it wanted to see sustained evidence that core inflation was falling. But wage growth pressures remain, and consumers’ inflation expectations are still elevated.
While the central bank said that it was prepared to hike rates further if needed, that statement is more likely to keep consumers’ inflation expectations in check rather than act as a credible threat.
But at this point, risks to the inflation outlook, which include geopolitical tensions, are largely beyond the Bank of Canada’s control. Holding the policy rate at 5% for too long could push the economy into a deeper-than-needed recession and hurt growth.
For this reason, the Bank of Canada will most likely lead the G7 in a gradual easing of interest rates starting in the second quarter of next year.