Bank of Canada: Target in Sight
We anticipate the Bank of Canada (BOC) will start reducing interest rates around midyear, as Canadian inflation slows toward its target. We estimate the underlying inflation trend to have fallen below the top end of the BOC’s 1%–3% inflation range by the end of 2023, and with economic growth stagnating in recent quarters, we believe further labor market easing will give the BOC the confidence to begin easing by midyear.
Following the large price shocks of the pandemic period, we think it has become increasingly important to distinguish between temporary and more permanent price shocks. To do this, we use a measure that focuses on labor market conditions and inflation expectations. This is likely to be a better indicator of inflation after pandemic-related shocks have completely faded.
This approach can be augmented with additional inflation measures, giving policymakers deeper insight into the drivers of inflation. Such measures include median and trim Consumer Price Index (CPI) inflation, which tend to show more persistence over time compared with the CPI excluding food and energy or the BOC’s previous preferred measure, CPIX,Footnote1 which focuses on excluding specific volatile sectors (see Figure 1).
It’s also crucial to note that rent and mortgage interest costs, constituting just over 10% of the CPI basket, have been significant drivers of recent core inflation. Counterintuitively, tighter monetary policy might worsen inflation in these areas rather than alleviate it. Recently, BOC Governor Tiff Macklem highlighted that nearly 45% of CPI categories are still experiencing inflation rates above 3%, citing this as a reason for suggesting inflation remains elevated. However, after excluding rent and mortgage interest costs, this figure falls to close to 35%, aligning with 2019 levels and suggesting a less worrisome inflation picture.
Figure 1: Canadian inflation is trending lower
Although the market is pricing a similar trajectory of rate cuts for the BOC and the Federal Reserve, Canada’s economy has been weaker. We think the pace of easing is likely to proceed more quickly than in the U.S. owing to three factors that are weakening the economy: faster mortgage renewals, a slowdown in immigration, and weaker labor market dynamics.
- First, as mentioned in our previous blog post, “The Straw That Broke the Camel’s Back?,” consumption in Canada has weakened as shorter mortgage terms mean households have faced the burden of renewals to higher mortgage rates faster than their American counterparts. Meanwhile, Canadian banks have subsequently reduced the practice of extending mortgage amortization periods to offset the impact of higher interest rates.
- Second, recent changes to immigration policy are likely to weigh on Canadian population growth, damping what has been a tailwind to economic growth. This is also likely to have implications for shelter inflation, with a slowdown in immigration (particularly with newly announced caps on permits for student visas) likely tempering rental demand and helping to ease what has been a stubborn component of the inflation basket.
- Third, the Canadian labor market has normalized at a faster rate than in the U.S. Vacancy rates are back to near pre-pandemic levels and the unemployment rate is nearly one percentage point above its post-pandemic low as labor demand has not kept pace with the rise in labor supply from increased immigration. While labor supply growth should slow, continued weakness in the economy and rising business insolvencies suggest labor demand may also slow, limiting the pace of economic recovery and damping labor-driven inflationary pressures.
All of the above should limit some of the upside risks to inflation and help assure BOC officials that they can begin normalizing policy rates by midyear.
In comparison, the U.S. economy has remained strong over the past year. Households have been more insulated from higher mortgage interest rates while strong labor demand has better absorbed immigration-led labor supply expansion. While we expect some slowing in the U.S. economy as excess savings are depleted and fiscal policy becomes less supportive, relatively tighter labor markets are likely to keep inflation elevated in the near term and limit the scope for rate cuts in the U.S.
Investment implications
The key takeaway from our assessment is that when easing starts, it could be more forceful and rapid in Canada than the U.S. Against this, markets continue to price the path of policy rates to be quite similar, leading us to believe that short-term bonds in Canada offer attractive value. We favor an overweight to two-year bonds in Canada, relative to both similar-maturity bonds in the U.S. and longer-dated Canadian bonds, which trade well below the overnight rate. As this path comes to be realized, we also expect it to weigh on the Canadian dollar and we thus favor maintaining a modest underweight.
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