(Bloomberg) -- The Bank of Canada is likely to make a jumbo cut to interest rates, acknowledging that borrowing costs should fall more quickly as inflation wanes and economic growth stagnates.
Markets and economists expect policymakers led by Governor Tiff Macklem will cut the policy rate by half a percentage point to 3.75% on Wednesday, the first reduction of that magnitude since the Covid-19 pandemic.
The large cut — which is expected by all but one of Canada’s biggest lenders — would signal some urgency to bring the benchmark overnight rate to the so-called neutral level, where it will neither slow nor stimulate the economy.
With inflation now lower than the central bank’s 2% target and growth tracking well below the bank’s estimates, restrictive borrowing costs simply aren’t needed. Some analysts also worry that sticking to a gradual easing pace at this point wouldn’t be enough to keep inflation from drifting too low, or might even lead to outright deflation.
“Arguably the Bank of Canada is well behind the curve,” Jason Daw, head of North American rates strategy at Royal Bank of Canada, said by email. “They had to wait due to inflation uncertainties, but with price growth normalizing quickly, the economy no longer needs the current degree of restrictiveness.”
In a news conference after September’s 25 basis-point cut, Macklem opened the door to the possibility of more aggressive action, saying the bank could accelerate the pace of easing if inflation and growth were weaker than expected. So far, that seems to be the case.
Yearly price pressures surprisingly decelerated to a 1.6% pace last month, helped by falling gasoline prices. They’ve averaged 2% in the third quarter, below the 2.3% pace forecast in July. At that time, officials expected the economy to grow at a 2.8% annualized clip in the third quarter — preliminary data point to growth closer to 1%.
Downside risks to the economy are mounting. While a recession is not the base case expectation of economists or the bank, growth has stagnated and is being propped up by record immigration levels. On average, the economy has been expanding below potential for over a year, opening the so-called output gap and helping to ease price pressures. The labor market is weakening, and while there’s no evidence of widespread layoffs, household spending is being constrained as Canadians continue to renew their mortgages at higher rates.
It’s rare for the central bank to opt for outsized rate cuts to normalize borrowing costs — usually it’s to contain recession risks. In the past three decades, there have only been three periods of larger-than-normal rate cuts: in 2001, after the US dot-com bubble and Sept. 11 attacks, during the global financial crisis in 2008-09, and in 2020, in the midst of the Covid-19 economic shock. Only the 2001 cuts didn’t coincide with a recession.
Macklem’s task is to communicate that the jumbo cut is not an indication that officials are becoming increasingly worried about a hard-landing scenario. That’s a big reason why the central bank isn’t likely to surprise with an even larger reduction of 75 basis points — though some observers, including Canadian Imperial Bank of Commerce Chief Economist Avery Shenfeld, aren’t ruling out the possibility.
“If a 3.5% or lower overnight rate is appropriate for three months from now, it’s hard to see why it wouldn’t be even better to get there sooner,” he wrote in a report to investors.
Still, there are other risks to cutting too quickly. Underlying price pressures are proving stickier than headline inflation. And activity in Canada’s housing market weakened as rates climbed in recent years. Lower mortgage costs risk stoking housing speculation, reversing some of the progress that highly leveraged households have made in paying down their debts.
“The biggest criticism of the Bank of Canada during the pandemic and pre-pandemic was that they contributed to the fueling of debt demand in Canada and home prices,” Beata Caranci, chief economist at Toronto-Dominion Bank, said in an interview. “We’re in the early stages of a small and stable deleveraging cycle and there’s a clear risk that if they get too aggressive, they completely unwind the soft landing on that side.”
Macklem and his officials cautiously started easing borrowing costs with a quarter percentage-point reduction in June. The bank cut again by that amount in July and September, bringing the policy rate to 4.25%.
In the monetary policy report accompanying Wednesday’s decision, policymakers are likely to lower estimates for gross domestic product growth and inflation over the next year. Officials are also expected to move up their timeline for inflation returning sustainably back to target, from the second half of 2025 previously.
In an interview with Bloomberg last month, before the latest job and inflation prints, former Bank of Canada Governor Stephen Poloz warned that trimming interest rates from restrictive levels in a gradual manner doesn’t always yield the desired impact on the economy, as firms and households may expect more rate cuts to come and wait before making purchase decisions.
“It’s kind of a movie, and they’d like to wait another six months to see how it’s going. It’s not a dramatic thing, but it just means that the economy probably won’t turn on a dime and immediately start to go,” he said.
--With assistance from Jay Zhao-Murray.
©2024 Bloomberg L.P.