Bank of Canada is at an important crossroads in its preparations to make a crucial decision regarding interest rates next week. Market expectations are split between a 25-basis point (bps) cut and a 50 bps more aggressive reduction.
The fourth reduction in three years.
BoC decision made difficult by the mixed signals coming from data on inflation, changing labor market and evolving economic forecast.
For the first time in February 2021, the consumer price index for Canada fell below the target of 2%.
Housing costs are a major contributor to the residual inflation; without them, inflation may fall below 1%.
The BoC can’t ignore certain components. This has led policymakers to be cautious when it comes to easing too quickly. The risk of a new price rise if the monetary policy is too relaxed should be a major concern.
Source: Think.ing
Growth outlook improves despite cooling inflation
Canada’s economy appears to be resilient despite a moderated inflation rate.
Recent GDP and retail figures have exceeded forecasts, according to the latest Business Outlook Survey.
The labor market is a more complex one. Unemployment has risen to 6,5% from 4,8% in July of 2022.
The rise in participation is due not to lost jobs but rather an increase of recent immigration.
The BoC could use this increased supply of labor to ease wage pressures and pursue its strategy for gradual rate cuts.
Central bank’s goal is to strike a balance between maintaining neutrality in policy and supporting economic growth.
The financial markets are predicting a cut of 50 basis points with a high degree of certainty
Financial markets have a tendency to take a more aggressive position, and are pricing in the likelihood that a policy cut of 50 basis points will be made at this meeting.
This cut, if implemented, would add to the 83bps reductions that are expected by December.
Investors’ expectations have changed. A week ago, the market expected 60 basis points of reductions.
The difference in interest rates between the BoC, the US Federal Reserve and the BoC would be increased by 50 basis points. This creates a 125-basis point spread.
It could put further pressure on Canada’s dollar (CAD), increasing the cost of imports and raising concern among some members of the BoC about an even larger rate cut.
Source: Think.ing
BoC could be influenced by the widening US-Canada differential in rates
BoC decision making is heavily influenced by the potential for the US and Canada interest rates to widen.
This spread would be amplified by a 50bps reduction, which could lead to further downward pressure on the Canadian dollar.
Weaker CADs could increase import prices, causing inflationary pressures and complicating the BoC’s aim of achieving stable price levels.
A 25bps reduction may be a prudent choice in light of these dynamics.
This would indicate a continued easing, while reducing the risks of a rapid decline in the Canadian dollar.
The decision is still finely balanced. A 50bps reduction in the rate could be a viable option depending on BoC inflation expectations.
Markets rise on dovish expectations as they await BoC’s decision
The gap between USD and CAD 2-year swap rates has widened since the beginning of October from 50bps up to 80bps.
The shift in Canadian expectations reflects the hawkish attitude in the US against a background of dovish rates in Canada.
This widening spread has driven the USD/CAD to 1,38. It is preventing the Loonie from gaining potential in the relative stability of currency crosses.
Market expectations of a 50% cut leave the CAD open to repricing if the BoC decides on a 25% reduction.
This scenario could lead to an appreciation in the short term of the Canadian dollar as investors adapt to a more moderate easing than originally expected.
What will Bank of Canada choose: A 25 or 50 basis point cut?
The BoC will ultimately decide between the 25-bps or 50-bps cuts based on their assessment of the inflation risk, the economic momentum and the effect of a lower CAD in the economy.
If the bank is cautious, it would prefer a cut of 25 basis points to allow for flexibility in future adjustment.
A more aggressive 50-bps reduction could indicate a greater commitment to support economic growth.
Markets will closely monitor the upcoming meeting, which could have significant impacts on Canada’s economy and its CAD.
Analysts and investors are on alert for volatility, as the central banks navigates through this difficult environment.
As new information becomes available, this post Bank of Canada must choose between rate cuts of 25 and 50 basis points may be updated.
