BoC Review: Attention Turns to Cuts

Summary

• The Bank of Canada (BoC) hiked the policy rate by 25bp to 4.50%, as we had expected. They also announced a conditional pause for the March meeting.
• Going forward, they have a short, but important checklist: services disinflation, retreating inflation expectations, moderating wage growth accompanied by increasing services productivity, and easing labour market tightness.
• An accumulation of opposing data would prevent them from pausing. Therefore, if they hike again, we think it would be in April when more data is available.
• We expect this to be the final hike of the cycle. Attention now turns to cuts. We have long thought BoC cuts are mispriced versus the Federal Reserve.

One Last Hike (Maybe)

The BoC hiked the policy rate by 25bp to 4.50% on Wednesday, as we had expected. The slowdown follows 425bps over the past eight meetings – averaging more than 50bp per meeting. A lot came with Wednesday’s hike. Notably, the suggestion that ‘core inflation has peaked’ helped spur their decision to conditionally pause at the March meeting.

This may seem dovish, but it was not. The BoC has signalled over the past two meetings that they wanted to see how the data evolves – they just needed economic data to pair with already weakened surveys. They got that. Moreover, a 4.50% terminal rate places them 50bp behind the current implied Federal Reserve (Fed) terminal rate (c. 5%) – read Dominique’s FOMC preview. Through the 21^st century, the BoC has concluded its hiking cycle 75bp shy of the Fed. So, by historical standards, this was a comparatively hawkish cycle.

What Could Force Another Hike?

To hike again, Governor Macklem said the BoC would need to see an ‘accumulation’ of evidence – i.e., not one data point – suggesting economic data momentum is turning. Specifically, they want to see services disinflation combined with retreating inflation expectations, moderating wage growth (with a pickup in services productivity) and easing overall labour market tightness. A combination of the opposite would force their hand. As it stands, services inflation momentum is collapsing (Charts 1 and 2). Monthly readings averaged +0.24% MoM through Q4, down from +0.43% MoM in Q3 and +0.69% in Q2.

Meanwhile, core inflation momentum is slowing, suggesting the peak in core inflation is forthcoming despite inflation expectations proving hard to budge (Charts 3 to 5).

However, wage growth is yet to make meaningful progress. Focusing on services, unit labour cost increased +5.2% YoY through Q3 2022 (Appendix: Table 1). That is +1.1% QoQ! This follows below-trend productivity (Appendix: Charts 6 to 9). Indeed, if wage growth persists without a meaningful return to trend in productivity, further hikes would be needed. We are watching this closely.

Lastly, the labour market is too tight for comfort. The unemployment remains 0.1pp above record lows, labour shortages have only just begun to ease, while the remaining seven below paint the same picture: the labour market is hot. We are tracking a snapshot of the BoC’s labour market metrics – there are 41 in total (Appendix: Table 2).

Have Markets Priced BoC Cuts Correctly?

Markets are pricing the BoC to cut the policy rate by 50bps by yearend. Governor Macklem dismissed the idea of cuts at this stage. Instead, he said the BoC must assess the incoming data. So, no clue there.

However, we have long thought the BoC (and Reserve Bank of New Zealand) will have to cut aggressively compared with the Fed. This is because their economies have taken on far more debt than the US since the GFC relative to their income. We can add to this their inflated housing markets and the unfavourable repayments there versus those in the US.

History suggests markets are being reasonable in pricing the first cut in October, unlike in the US. With October nine months away, that would keep the BoC on hold for longer than in the 00’s. However, it leaves them short of the average (across 00/01, 06/07, 18/20) of 14 months.

What Will Happen to BoC Losses?

The latest topic: who deals with central bank losses? Typically, the BoC has made net earnings. And when they have, they paid those net earnings (as remittances) to the Canadian government. That is because current legislation forbids the BoC from retaining earnings. This, however, has left the BoC unable to cover its losses. Thankfully, the Department of Finance has come to the rescue, temporarily allowing the BoC to retain earnings to offset losses. Once positive equity is restored, remittances will resume to the government.

Note, BoC losses have no impact on monetary policy decisions.

Appendix

Ben Ford is a Researcher at Macro Hive. Ben studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively.

The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)