After this week’s decision by the Federal Reserve to initiate an easing cycle with a half-percent rate cut, there has been speculation that the Bank of Canada might follow suit at its next policy meeting on October 23rd. It’s foolish to rule out anything these days, but the odds still favour a steady procession of quarter-point moves by the Bank.  This week, we will examine the factors that support that forecast and those that could prompt a more aggressive easing stance.

The first thing to keep in mind is that the Bank already has reduced its overnight target rate by 0.75% this summer compared to 0.5% for the Fed. Consumer price inflation continues to moderate and this week we saw headline rate fall to 1.95% for August and the core rate (CPI-median) edged down to 2.3%. For a central bank with an official inflation target of 2%, this is mission accomplished.

While some believe that the extent to which interest rates were increased has already pushed the economy into recession, the reality is that the only contraction that has taken place is in the country’s output gap.  The Bank has made several mentions in recent months to how the economy has shifted from a position of excess demand, as a result of the massive post-pandemic stimulus programs, to one of excess supply. Another way of looking at this is with reference to what we call the output gap, or the difference between actual output the nation’s potential output.

When the output gap is positive, then the demand for goods and services exceeds available supply, which can lead to higher inflation. Lifting interest rates to address that imbalance eventually causes demand to slow relative to supply. As the above chart shows, the output gap has turned negative over the past year, but the size of this gap is no greater than what was estimated in 2017 or 2010. Bringing rates back to levels that would be consistent with a balance between demand and supply is appropriate, but the data doesn’t suggest that aggressively large moves are needed.

The moderation in inflation started off with the goods side of the economy, as spending on discretionary items was curtailed. This was not only true at the consumer level, but we also saw pipeline inflation pressures abate further up the supply chain. Producer prices, as measured by the Producer Price Index (PPI) actually started to decline and resulted in actual deflation by 2023. As the chart below shows, Canada went from experiencing peak PPI inflation of 18% in the spring of 2022 to minus 5.5%. That reversal was the largest on record, but prices stabilized, and we are now back to inflation of close to 3%.

Some of this can be attributed to a general weakening in the value of the Canadian dollar, from a high near 76 US cents around this time last year to a recent low of 72 cents at the start of August. Since a weaker currency can lead to higher prices for imported items, that can potentially flow through to what we pay at the retail level, then the Bank of Canada would have to take this into account when setting policy. For now, the lift in PPI inflation doesn’t preclude the need for getting rates back down to more normal or equilibrium levels, but it also argues against the need for a rapid change.

If the economy is okay, then would there be another reason why a central bank should resort to mega cuts in rates? In other words, is the financial system broken to the extent that there is or will be a major knock-on effect on the economy? Think back to the Great Financial Crisis or the pandemic. The mini banking crisis in the U.S. back in the spring of 2023 sort of looked as though something had broken, but measures taken by the Federal Reserve were sufficient to restore calm without going to the interest rate tool chest.

There are several metrics that we look at to gauge the financial health of an economy. These include measures like delinquencies on business and consumer debt and default ratios. An indication of stress would be if borrowers were finding it difficult to make payments or actually repay their debts. A rise in non-performing loans, or NPLs, would suggest that segments of the economy are coming under stress and might require an adjustment in monetary policy to alleviate that stress. In the above chart, we show the percentage of Canadian loans that are non-performing. As you can see that ratio has been rising of late, but at 0.48% we are still below levels seen in 2016 and 2020. Again, there is clearly a need to adjust policy, but no one should be panicking.

A jumbo move by the Fed this week has led some to believe the Bank of Canada should play copycat and perhaps the economic data in coming weeks might support such a decision, though I doubt it. Assuming we see two more quarter-point cuts in the Bank’s last meetings of the year, this would take the overnight target to 3.75%. Even if there are only four such moves next year (out of eight meetings), this would still keep us on course for a “terminal” rate of 2.75% - more or less in line with what the Fed’s dot plot suggests for the U.S.  From where Ally and I sit, there is no change to the outlook nor our strategy for both the bond portfolio and equities.

On behalf of the Pyle Wealth Advisory team, have a great weekend.   

Andrew Pyle