David Rosenberg: Poor economy means Bank of Canada has to keep cutting rates
The Bank of Canada’s recent actions reflect a fundamental shift in its assessment of the Canadian economy. Recent data indicate the economy is operating in a state of excess supply, necessitating continued rate cuts. Governor Tiff Macklem and the central bank initially discussed this situation at the April 10 meeting, and the subsequent delays in initiating the rate-cutting process highlight a missed opportunity. The market is currently priced for only two cuts over the next four meetings, a conservative estimate given the prevailing economic conditions.
The Canadian economy moved into “excess supply” last summer, yet the Bank of Canada raised rates twice more, bringing them to five per cent from 4.5 per cent. This overshoot underscores a policy misjudgment. When the economy enters this state – characterized by underutilized capacity and weak demand – the appropriate policy rate typically hovers around three per cent, not the 4.75 per cent the Bank of Canada maintained. The market’s expectation of just two cuts represents a belated recognition of this reality.
The Bank of Canada’s actions are driven by a desire to address not only the current inflationary pressures but also to correct a past oversight. In 2021 and 2022, the economy was operating with an “excess supply” output gap, yet the central bank clung to a hawkish stance, raising rates to 4.5 per cent. This delay stems from a reluctance to repeat the mistakes made during the “transitory” period – a term that proved misleading in the face of persistent inflation.
Currently, the unemployment rate has climbed 140 basis points from the cycle low of 4.8 per cent to 6.2 per cent. Historically, this rise in the jobless rate has not been associated with avoided recessions; over the past six decades and five recessions, a jobless rate increase of this magnitude has never prevented a recession. This highlights the urgency with which the Bank of Canada must act.
The 6.2 per cent unemployment rate, significantly higher than the 5.5 per cent level before the onset of COVID-19 in early 2020, paints a clear picture. The Consumer Price Index (CPIX), the primary inflation gauge, is currently 1.65 per cent, a stark contrast to the 1.8 per cent recorded prior to the pandemic. This disparity demonstrates the tangible shift towards an “excess supply” economy.
Several factors justify the Bank of Canada’s commitment to continued rate cuts. Firstly, fiscal stimulus remains absent in Canada, while a significant amount of stimulus persists in the United States under the Biden administration. Secondly, Canada lacks 30-year fixed-rate mortgages, leading to faster resets in interest rates compared to the U.S. market. The U.S. stimulus checks, a key component of “Bidenomics,” have fueled continued consumer spending, a dynamic absent in Canada. Canada’s real GDP growth at 0.5 per cent, compared to the U.S.’s nearly three per cent, further underscores the divergence.
The Bank’s actions are further supported by a desire to mitigate potential damage to the Canadian dollar. A weaker loonie would be beneficial to the domestic economy, particularly as industrial production has dropped 1.6 per cent year-over-year and manufacturing employment is negative. The sector faces virtually no pricing power, with producer price inflation flirting near one per cent year-over-year, a far cry from the levels seen in the past. During prior Bank of Canada policy divergences with the U.S. Federal Reserve, the Canadian dollar experienced a retreat to around 70 cents U.S., a scenario we are nearing.
However, the Bank of Canada’s moves must be carefully considered against the backdrop of evolving global economic conditions. The market’s expectations of just two cuts are overly conservative. The overnight rate could touch two per cent, a more realistic and even potentially a more aggressive target. The market is currently priced for a steeper Government of Canada bond curve – a trajectory that could benefit investors. Additionally, a weaker loonie would enhance the attractiveness of Canadian exports.
The Bank of Canada’s ultimate goal is to shift the narrative from one of “excess supply” to one of demand-driven growth, aided by a lower policy rate. The journey will take time, but the current economic indicators and the Bank’s response align with the necessary corrective measures.
