Since the peak of rates in 2024, Canada and U.S. monetary policy have moved in the same direction, but on different glide paths. From June of last year, the Bank of Canada (BoC) has lowered its overnight target by a total of 2.75%, down to 2.25% this week after its decision to cut an additional quarter-point. The Federal Reserve also dropped its key rate by the same amount, taking it down a total of 1.5% from its high of 5.5%. Equity and fixed income investors have been factoring in additional easing into next year on the basis of a tilt in the balance of risks towards weaker employment versus inflation, yet as this week’s meetings demonstrated, that tilt may not be as significant as some believe.

The discussion of where policy rates in Canada and the U.S. go in the coming months and quarters has to start with where they are today relative to what each central bank considers to be “neutral”. Economists also refer to this estimate as “R-Star”. While not an observed number, the neutral rate is basically a level which is neither restrictive nor stimulative. Similar to other estimates of equilibrium, like the potential growth rate for the economy, it is a moving target. And since it is a moving target, monetary policy best practices employ a range approach instead of a bullseye. The below chart shows the BoC overnight target rate and the Federal Reserve upper target rate back to the pandemic. The estimated neutral range for the BoC is currently considered to be around 2.25% to 3.25%, while the range for the Fed is somewhere between 2.5% and 3%.

That said, at times where the balance of risks is heavily slanted one way or the other, it does provide a guide. Back in 2022, the balance of risks for both countries was heavily skewed towards high inflation. Even if neutral rate estimates were in flux, especially due to distortions caused by the pandemic and an inability of economic models to provide clear direction, ranges suggested that rates were too stimulative and needed to be adjusted higher. As inflation abated last year and we started to see a few cracks in the economic fabric, those ranges guided both central banks to a pivot on policy, suggesting rates were then too restrictive.

Once a shift in policy takes place, it is important to distinguish between the phases of that shift. In the current situation, both the BoC and Fed start by removing the degree of restrictiveness from policy. The second step is ascertaining whether or not rates are within their neutral range. Finally, if economic conditions are sufficiently weak and inflation is at or below target, then the decision is made to move rates to a level that is under the neutral range. Although it looks as though the BoC and Fed are keeping pace with each other after announcing back-to-back rate cuts in the last two meetings, they are different in terms of where they are in that first phase.

Let’s start with the BoC. Starting in June of last year, the Bank initiated five consecutive rate cuts – the first three being quarter-point moves and the final two being half a percent each. Those decisions took the overnight rate to the upper end of the neutral range. Two more cuts in the first quarter of this year, ahead of Trump’s tariff tantrum, effectively brought rates to the middle of the range. After this week’s cut, we are close to or at the bottom of the range. Again, this doesn’t mean that the Bank’s moves are creating stimulus. They have just taken policy out of the restrictive zone.

Unlike the Fed, which has a dual policy mandate of maximum employment and price stability, the BoC has only one target and that is inflation. That’s not to say that the Bank doesn’t take into account the state of the economy in its deliberations, but the clues provided by the economic data are factored into its estimate of whether Canada is operating at, above or below its capacity. The below chart shows Canadian CPI inflation and the national unemployment rate. 

You can see that there has been a marked increase in joblessness, with the rate rising from its low of around 5% in 2022 to 7.1% as of September. This has coincided with a sharp decline in inflation from a peak above 8% towards the Bank’s stated 2% target. Now, the September print was a little hot, but this still appears to be more a consolidation than the start of a new uptrend. The recent Trump move to impose 10% tariffs on Canada because of his hurt feelings following the Regan ad could add some upward pressure to inflation, but the Bank is more focused on growth.

As Governor Maklem said at Wednesday’s press conference, monetary policy cannot fix the damage created by tariffs and cannot bring Canada’s economy back to its pre-tariff state, but at 2.25% the official rate is viewed as appropriate for now. Market participants took that to mean the Bank is not 100% certain that an additional cut in rates in December is needed. There is also a federal budget coming down the pipe on November 4th, which is going to contain a fair dose of fiscal stimulus. Much of that will not positively impact the economy over the near-term, but some will. Moreover, Maklem was emphatic that this is not a normal cyclical development in the economy, but a structural one with scarring from U.S. policy. If the structural effects cause the economy to grow below its potential for a protracted period of time, widening the so-called output gap, then the Bank has access to another nine rate cuts and other tools to shift into full-on easing mode. For now, they are keeping that powder dry.

South of the border, there was a similar message from Chair Powell following the quarter-point cut. The move was appropriate today, but December was not a given. This desire to leave its options open stems from a few factors. One is that there is less official government data to base decisions on now, thanks to the second longest federal shutdown on record. While we did get a September CPI report, the last payrolls data goes back to September. And if the shutdown persists, there won’t be an October report either. Employment growth did slow in the summer, yet the unemployment rate is still in the low 4% area, as you can see in the above chart. Whereas headline inflation is definitely on the wrong side of 2%. In other words, the tilt in the balance of risks for the U.S. is not as material as for Canada. This reality also showed up in the two dissenting votes at Wednesday’s FOMC meeting. Yes, Trump’s hand-picked governor, Miron, wanted a half-point cut (again), but Kansas City Fed president Schmid voted to not lower rates.

This is clearly not the backdrop for the Fed to plough ahead with guidance of an additional cut before year-end or into 2026. That doesn’t mean there isn’t an argument for that to happen. For one, the fed funds rate is still a full percent above the top of its estimated neutral range, implying that policy is still restrictive. The four remaining cuts to get it there is what has been factored into at least equity projections, but perhaps Powell didn’t want to let the market run.

Ironically, Powell didn’t draw much criticism from Trump, but he did from dovish leaning economists. The reliance on the lack of government data as a reason for blurring the guidance has been viewed as a bit of a crutch. Not so much had the meeting been a couple of weeks ago, but it coincided with a slew of announcements from large-cap U.S. companies that thousands were going to be laid off. This included 48,000 operational and management positions at UPS and up to 30,000 office staff at Amazon.

These might be a couple of outliers or the start of a trend of broader firings. If the latter, then we are likely to see this reflected in the Challenger Gray Christmas layoff stats for October, but we are now also getting weekly reports from ADP with 4-week moving average payroll stats. Recall that in September, ADP reported a 32,000 decline in payrolls and the numbers for October 11th showed a small gain of only 14,250 per week on average over the past four weeks. The above chart shows the now stale non-farm payrolls monthly change against the change in ADP patrols.

If this deterioration in labour market activity is real, then the December Fed cut becomes all but guaranteed and markets will maintain pricing for additional easing in the first quarter of 2026. Hence why Powell’s mild push back against this anticipation caused stocks to trip a little. Note, if the labour indicators are correct, thus reinforcing market expectations, this could also throw a wrench into the works of the “resilient consumer” story. Despite the positive influence of lower rates, equities would likely stumble in response.

Bottom line, the BoC and Fed followed different paths in the initial shift from excessive restrictiveness towards neutral. It looks like those paths might now be converging as the Fed continues along a path towards its R-Star, while the BoC sits tight around its own for the time being. All things being equal, that should lead to an appreciation in the Loonie, and it is has been our view for a while now that the Canadian dollar will continue the uptrend from last year. We also believe that the balance of risk has shifted towards weaker economic growth and that reinforces a tilt on the equity side towards quality and value.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend and Go Jays Go!   

Andrew Pyle