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The Bank of Canada highlighted stubborn inflation as a key reason it kept interest rates hold, even as the economy showed signs of slowing. Andrew Kelvin, Head of Canadian & Global Rates Strategy with TD Securities, discusses the outlook for rates going forward with MoneyTalk’s Greg Bonnell.
Greg Bonnell: The Bank of Canada is holding its key rate steady at 5% amid concerns that underlying inflation measures are not showing sustained declines. Now, joining us with more is Andrew Kelvin, Head of Canadian and Global Rates Strategy with TD Securities. Not a big surprise that they held where they are. But some of the rationale there, they seem pretty concerned about core inflation. Are they right to be concerned? Are you concerned?
Andrew Kelvin: I don’t know if I’d say I’m concerned, but I do think this was the appropriate stance and the appropriate emphasis. Governor Macklem really tried to communicate the message that the Bank of Canada believes that they have tightened sufficiently to bring inflation back to the 2% target.
But just because they’ve hit the level that they think they need to get to to tame inflation, it doesn’t mean they can just quickly go and touch 5% and turn right around. They are now going to be entering a phase where they start debating, how long do rates need to be at 5%?
They’ve of course held out the caveat that if inflation becomes stronger again, they could raise rates again. And that’s always the case with the central bank. But ultimately now, it’s a question of, how quickly do they see that progress on underlying inflation?
The most recent CPI prints we’ve had have shown very limited progress. The economy has slowed enough that they do believe that we will see more slack enter the economy, price pressures start to wane.
The timing for rate cuts will ultimately just depend on how quickly inflation normalizes. And again, I would share the governor’s sort of focus on underlying inflation because given the data we’ve seen, it doesn’t appear to us that we will be looking at a reasonable discussion on rate cuts in the next meeting or two.
Greg Bonnell: Well, let’s talk about that then because the market has certain expectations. And probably, maybe around June, it might be a bit of a coin toss about when the governor has asked, he basically just said over it is premature at this point to talk about rate cuts, the conversations about how long we stay here now.
Is the market getting ahead of things, or is the market sort of seeing something in the economy that gives it some sort of comfort that by the summer or the late spring, maybe we’re talking about rate cuts?
Andrew Kelvin: I think the market – because the market’s weighting probabilities. And given that the Bank of Canada has really moved away from sort of credibly threatening rate hikes, the market’s right to be pricing in incrementally higher probabilities of rate cuts with each successive meeting.
March, there’s not a lot of time between this January meeting and the early March meeting. So I think a March rate cut would need to – would be a really significant about face for the Bank of Canada. Things would need to go very poorly very quickly to start talking about that.
And it’s a fairly narrow path for April. Though by April, if you have a few downside surprises on CPI, we can be talking about that with a lot more urgency, I think.
There is still a lot of the game left to play between now and the April meeting. In terms of what the market’s looking for, the market will ultimately, ahead of the meeting, which Bank of Canada cuts, the market will probably have arrived at that probability.
But if you want to get a more holistic view, there’s about 100 basis points of easing priced in for 2024. I think that’s pretty reasonable. It’s just a question of when they start.
Greg Bonnell: Let’s talk about housing. The Bank of Canada itself acknowledged in today’s decision that shelter costs, in their words, remain the biggest contributor to above target inflation.
So a question was put to the governor, after they gave their statement, basically saying if this is what remains, and to get us back to 2% inflation, why don’t you just start cutting rates and give Canadians a break? His answer was it’s a little more complicated than this. I know you’ve been delving into this issue too.
Andrew Kelvin: So there’s a few ways of thinking about this. So now, the bank said, in the monetary policy report, that they expect that shelter inflation will remain a headwind to achieving their target of 2% inflation for several years.
So they’re not expecting a quick normalization in shelter price inflation. They also said in the press conference opening statement that they are resolute in trying to achieve their 2% inflation target.
So if you’re saying that shelter price inflation is probably going to be above 2% for more than one monetary policy cycle, for more than one or two years, and you’re saying that you’re going to get to 2%, you’re saying that you need to see other parts of the economy see lower than 2% inflation to compensate for this sort of very stubborn, sticky shelter inflation. Now, it isn’t just shelter. The share of the CPI basket that is above 4% is above historical norms.
Normally, you’d look for that to be sort of 25% to 30% of the basket being above 4%. That figure now is in the sort of mid-40s. So it’s not just a shelter thing.
The shelter component, some of the more inflationary shelter components, are filtered out of their core inflation measures, which are running about 3 and 1/2%. So shelter is the biggest contributor. This isn’t just a shelter story. And moreover, their mandate is 2% inflation. Their mandate is not 2% inflation excluding shelter.
And if you just think about the arithmetic of this, if they were to target 2% ex shelter inflation while acknowledging that shelter inflation is going to be above 2%, at that point, you’re no longer targeting 2% inflation. And that, honestly, is not their call to make unilaterally.
They have an agreement with the federal government. That is where the sort of democratic legitimacy of the Bank of Canada exerting such powerful control over the economy comes from. They have an agreement with the government. And their agreement is 2% inflation.
Greg Bonnell: Now, of course, they made pretty clear, as you said off the top of our conversation, that the conversation around the table for them now is about, how long do we stay at these levels? We’re not talking really about a hiking environment anymore. It’s premature to talk about cuts.
But they did say that you can’t take – they can’t paint themselves in a corner and say, well, we won’t hike if the world doesn’t change. What could happen that would make that world change for us this year, and they would end up having to hike again?
Andrew Kelvin: You would need to see I think a lot more resilience from Canadian households than we’ve seen thus far. 2023 is a really poor growth year. The middle part of the year, we saw probably zero growth.
Well, we saw zero growth through the middle part of the year. We probably saw something pretty close to zero in the fourth quarter as well. So it’s already 3/4 of essentially flat economic activity. And we are not looking for a big rebound in the first part of 2024.
We’ve seen that employment rise by one percentage point. All those things sort of point to a softening price environment in the future. If the economy were to rebound dramatically, if we were to go into the spring housing market, and that ignites the animal spirits, which just reignite a broad consumption frenzy, hypothetically – I don’t expect this will happen, but as an example, something that could happen that would cause the Bank of Canada to change tact, we need to be talking about a much more robust Canadian growth outlook.
I think a combination of stubborn inflation and slow growth is probably something that’s more consistent with the Bank of Canada just staying at 5% for a prolonged period of time. So really, for the bank to turn and have to hike, things need to be a whole lot better on Main Street.
Greg Bonnell: Let’s talk about something that often gets overlooked. I know it doesn’t get overlooked by you and your team in your work. But I mean, the first paragraph of the statement is today, we held our target for the overnight rate at 5%.
This is news everybody is looking for. And you feel like sometimes they jump over the fact. They say, oh, and we’re continuing our policy of quantitative tightening. Are we not paying enough attention to that part of the equation?
Andrew Kelvin: So the quantitative tightening question, I think, will start to become a lot more to – it’s started to become more topical already. So the Bank of Canada, when the pandemic happened, started buying huge amounts of government bonds to lower interest rates to support the economy.
They stopped buying those bonds about a year and a half ago. They just were not buying bonds anymore. The thing is in normal times, the Bank of Canada actually is constantly buying small portions of government of Canada bond issues. They need to hold assets on their balance sheet against their liabilities.
The primary one used to be currency, bills and circulation. So they would hold government of Canada bonds and T-bills against those. And they did it in the most unobtrusive way possible. That was their goal.
They didn’t want to be influencing the market. They just needed to hold these things. And then as they matured, or as the number of bills in circulation rose, they’d buy a little bit more.
The issue now is we’re trying to find the new normal for the size of the balance sheet. So they’ve been sort of on autopilot, letting bonds mature. They fall off their balance sheet. The size of their balance sheet shrinks.
They will, at some point, reach the sort of normal level of their balance sheet, which, based on the most recent speeches they’ve given on the topic, which were quite some time ago, they were last spring, I believe, they think that point comes in the fourth quarter of 2024 or the first half of 2025. That’s their last estimate, which is an estimate.
Why this matters is because we’ve seen the government of Canada start to increase their bond issuance to fund deficits and a bunch of other things, investments they want to make and the like.
We’re probably going to see a pretty aggressive government of Canada borrowing program in fiscal ’24-’25, just given bond maturities, the nature of finance, deficits that are on tap, and other things that they would like to do that aren’t necessarily captured in deficits.
When the Bank of Canada starts buying bonds to stabilize their balance sheet, that will take a little bit of the pressure off the Canadian bond market. And it’s sort of an awkward one for the Bank of Canada because they won’t restart because they’re trying to influence yields. But their balance sheet…
Greg Bonnell: The timing’s just sort of lining up.
Andrew Kelvin: And their balance sheet. And they really, really don’t want to be seen as someone who is, quote unquote, “bailing out the government.” They hate that framing. But at some point, they’re going to end quantitative tightening because their balance sheet will be the right level.
And when their balance sheet is the right level, they will start buying government of Canada bonds again, which is something that will – the margin impact yields.
