Key Takeaways:

• Bank of Canada reduces target overnight rate to 4.5%
• Decision reflects growing concerns about economic slowdown and persistent excess supply
• Inflation expected to return to 2% target by 2025
• Bank balancing risks of over-tightening against stubborn inflationary pressures

The Bank of Canada (BoC) announced today a further 25 basis point cut to its benchmark interest rate, bringing the target for the overnight rate down to 4.5%. This marks the second consecutive rate reduction in 2024, signaling a significant shift in the central bank’s monetary policy stance as it grapples with a cooling economy and persistent excess supply. The decision underscores the complex challenges facing policymakers as they navigate the post-pandemic economic landscape and attempt to strike a delicate balance between controlling inflation and supporting economic growth.

Economic Context

Global Outlook

The global economy continues to expand at a moderate pace, with growth expected to hover around 3% annually through 2026. This relatively stable growth trajectory comes against a backdrop of ongoing geopolitical tensions, supply chain realignments, and the lingering effects of the COVID-19 pandemic. While inflation remains above central bank targets in most advanced economies, it is forecasted to ease gradually, reflecting the impact of tighter monetary policies implemented over the past two years.

In the United States, Canada’s largest trading partner, the anticipated economic slowdown is materializing. Consumption growth is moderating, likely due to the cumulative effect of interest rate hikes by the Federal Reserve. U.S. inflation appears to have resumed its downward path, offering some relief to policymakers and consumers alike. This trend is particularly significant for Canada, given the close economic ties between the two nations and the potential spillover effects on Canadian exports and inflation dynamics.

The euro area is showing signs of recovery after a weak 2023, with growth picking up despite ongoing energy challenges and geopolitical uncertainties. This resurgence in European economic activity could provide a boost to global trade and potentially benefit Canadian exporters in the medium term.

China’s economy is growing modestly, with weak domestic demand partially offset by strong exports. The world’s second-largest economy continues to grapple with structural challenges, including a troubled real estate sector and shifting demographic trends. The trajectory of China’s economic recovery remains a key factor in global growth projections and commodity prices, both of which have significant implications for the Canadian economy.

Global financial conditions have eased in recent months, characterized by lower bond yields, buoyant equity prices, and robust corporate debt issuance. This loosening of financial conditions could support economic activity but also presents risks of asset price inflation and potential financial instability.

Canadian Economic Performance

Canada’s economic growth has been tepid, with GDP likely expanding by about 1.5% through the first half of 2024. However, this growth rate falls short of the economy’s potential output, which is expanding more rapidly due to robust population growth of approximately 3%. As a result, excess supply in the economy has increased, presenting a challenge for policymakers seeking to balance growth and inflation targets.

Key indicators of economic weakness include:

1. Soft household spending, encompassing both consumer purchases and housing activity
2. Signs of slack in the labor market, with the unemployment rate rising to 6.4%
3. Employment growth lagging behind labor force expansion
4. Job seekers facing longer search periods

The weakness in household spending is particularly noteworthy, as it has traditionally been a key driver of Canadian economic growth. Several factors contribute to this softness:

• Higher interest rates have increased debt servicing costs for many households, reducing discretionary spending power.
• The housing market has cooled significantly, impacting both residential investment and related consumer spending.
• Lingering economic uncertainty may be prompting households to increase precautionary savings.

The labor market, while still relatively tight by historical standards, is showing signs of easing. The unemployment rate has risen to 6.4%, reflecting a divergence between employment growth and labor force expansion. This trend is particularly pronounced among younger workers and new immigrants, who are facing longer job search periods. The softening labor market could have implications for wage growth and, by extension, inflationary pressures in the service sector.

Inflation Dynamics

The BoC’s decision to cut rates is largely influenced by the evolving inflation picture. CPI inflation moderated to 2.7% in June, down from a slight increase in May. This moderation is welcome news for policymakers who have been battling persistently high inflation for the past two years. Broad inflationary pressures are easing, with the Bank’s preferred measures of core inflation remaining below 3% for several months.

However, the inflation landscape remains complex, with certain sectors continuing to experience elevated price pressures:

1. Shelter costs remain a significant contributor to overall inflation, driven by rising rents and mortgage interest costs. The housing market’s dynamics, including supply constraints and demographic pressures, continue to exert upward pressure on shelter-related inflation.
2. Services closely tied to wages, such as restaurants and personal care, still exhibit high inflation rates. This “sticky” service sector inflation is a concern for policymakers, as it can be more persistent and challenging to address through monetary policy alone.
3. Food inflation, while moderating, remains above the overall CPI, impacting household budgets and potentially influencing inflation expectations.

The BoC expects its preferred measures of core inflation to slow to about 2.5% in the second half of 2024 and gradually ease through 2025. This projection is based on several factors:

• The lagged impact of previous interest rate hikes continuing to work through the economy
• Easing global supply chain pressures
• Softening domestic demand due to higher borrowing costs and economic uncertainty

CPI inflation is projected to dip below core inflation later this year due to base-year effects on gasoline prices, before settling around the 2% target next year. This trajectory, while encouraging, is subject to various risks and uncertainties, including potential energy price shocks, exchange rate fluctuations, and shifts in global economic conditions.

Economic Projections and Monetary Policy Transmission

The Bank of Canada has revised its economic growth projections:

• 2024: 1.2% GDP growth
• 2025: 2.1% GDP growth
• 2026: 2.4% GDP growth

These forecasts anticipate a gradual strengthening of the economy, with excess supply being absorbed through 2025 and into 2026. The projected recovery is expected to be driven by:

1. Stronger exports, benefiting from a gradual improvement in global demand and a relatively stable Canadian dollar
2. A rebound in household spending as borrowing costs ease and consumer confidence improves
3. Increased business investment, supported by easing financial conditions and the need to enhance productivity
4. Robust growth in residential investment, reflecting pent-up housing demand and demographic pressures

It’s worth noting that the Bank expects population growth to slow in 2025 due to new government limits on admissions of non-permanent residents, which could impact long-term growth prospects. This demographic shift adds another layer of complexity to Canada’s economic outlook, potentially affecting labor market dynamics, housing demand, and overall economic growth.

The transmission of monetary policy to the real economy is a critical consideration for the BoC. The recent rate cuts are expected to work through several channels:

1. Lower borrowing costs for households and businesses, stimulating spending and investment
2. A potential weakening of the Canadian dollar, which could boost export competitiveness
3. Positive wealth effects from potentially higher asset prices, particularly in the housing and equity markets
4. Improved business and consumer confidence, encouraging spending and investment decisions

However, the effectiveness of these transmission mechanisms may be influenced by various factors, including high household debt levels, global economic uncertainties, and potential structural changes in the post-pandemic economy.

Policy Considerations and Risks

The BoC’s Governing Council is carefully balancing several factors in its decision-making process:

1. Downside Risks: With inflation moving closer to the 2% target, the risk of over-tightening monetary policy and unduly weakening economic activity has increased. The Bank is mindful of the potential for a more severe economic slowdown if policy remains too restrictive for too long.
2. Persistent Inflationary Pressures: Price pressures in key sectors like housing and services remain elevated, potentially slowing the return to target inflation. The Bank must weigh the risk of premature easing against the need to anchor inflation expectations.
3. Labor Market Dynamics: While there are signs of moderation in wage growth, it remains elevated, which could contribute to sticky inflation in service sectors. The BoC is closely monitoring wage trends and their potential impact on overall inflation.
4. Global Economic Uncertainties: Geopolitical tensions, including ongoing conflicts and trade disputes, pose risks to Canada’s export-oriented economy. The Bank must consider how global developments might affect domestic economic conditions and inflation.
5. Financial Stability Concerns: While not explicitly part of its mandate, the BoC must also consider the potential impact of its policies on financial stability. Lower interest rates could reignite concerns about housing market imbalances and excessive risk-taking in financial markets.
6. Fiscal Policy Interactions: The effectiveness of monetary policy is influenced by fiscal policy decisions. The Bank must calibrate its actions in light of current and anticipated fiscal measures at both federal and provincial levels.
7. Long-term Structural Changes: The pandemic has accelerated certain structural changes in the economy, such as digitalization and remote work. The BoC must assess how these changes might affect the neutral interest rate and the overall transmission of monetary policy.

Looking Ahead

The Bank of Canada’s decision to cut rates for the second time this year marks a pivotal moment in its monetary policy trajectory. Governor Tiff Macklem emphasized that while the expected direction of policy rates is lower, the Bank is not on a predetermined path. Future decisions will be guided by incoming economic data and their implications for the inflation outlook.

Market participants and economists are now closely watching for signals of further rate cuts in the coming months. The next scheduled rate announcement is on September 4, 2024, which will provide another opportunity for the BoC to assess the impact of its recent policy actions and adjust course if necessary.

Key indicators that will influence future policy decisions include:

1. Inflation data, particularly core measures and service sector inflation
2. Labor market statistics, including wage growth and participation rates
3. GDP growth and its components, especially consumer spending and business investment
4. Housing market trends and their impact on overall economic activity
5. Global economic developments, particularly in the United States and major trading partners

The Bank’s communication strategy will be crucial in managing market expectations and guiding economic actors. Clear and consistent messaging about the policy outlook and the factors influencing decisions will be essential in maintaining the BoC’s credibility and effectiveness.

As the Canadian economy navigates this period of transition, the Bank of Canada remains committed to its primary mandate of maintaining price stability. However, it is clear that policymakers are increasingly mindful of the delicate balance between taming inflation and supporting economic growth in an uncertain global environment.

The coming months will be critical in determining whether the BoC’s current policy stance is appropriate to achieve its inflation target while supporting sustainable economic growth. As always, the path of monetary policy will depend on the complex interplay of domestic and international economic forces, requiring vigilance, flexibility, and careful analysis from Canada’s central bankers.

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