(Bloomberg) -- The Bank of Canada is likely to cut interest rates by half a percentage point for a second consecutive meeting, bringing borrowing costs to more neutral levels and better positioning the economy for the potential crosswinds of a tariff war.
Markets and most economists expect policymakers led by Governor Tiff Macklem will cut the benchmark overnight rate by 50 basis points on Wednesday. That would bring the policy rate to 3.25%, the top end of the range of the central bank’s estimate for the neutral rate — a theoretical level where borrowing costs neither stimulate nor restrict the economy.
With inflation hovering near the 2% target, the central bank has said it’s now looking for economic growth to pick up in order to achieve a soft landing. In October, the Bank of Canada cut borrowing costs by half a percentage point. A second move of that magnitude is likely to give the economy a stronger boost.
“We’re still in that excess-supply zone for the economy and it doesn’t look like the output gap is closing in the direction that the bank wants it to,” Veronica Clark, an economist with Citigroup, said in an interview, meaning the economy is underperforming relative to its potential. “The Canadian economy doesn’t need restrictive rates anymore.”
After overseeing one of the most difficult inflationary periods in the central bank’s history, Macklem is now faced with normalizing rates while weighing a response to a potential trade dispute. The severity and duration of that battle are unknowable until Donald Trump is inaugurated and his policy is fully outlined.
Macklem’s task is to keep focus on monetary policy that suits the lackluster near-term data, while communicating that the central bank will not react to trade threats or incorporate them into its models until it has more clarity.
“There is a reasonable case to be made that the deepening trade uncertainty with the US is alone a justification for an easier stance, to help inoculate the economy from external pressure,” Doug Porter, chief economist at the Bank of Montreal, wrote in a report to investors.
Last month, Trump said he’d apply 25% tariffs to all Canadian goods imported into the US, a move that would shatter Canada’s economy, and a threat he repeated this week. On Monday, Prime Minister Justin Trudeau said he’d respond in kind, though he didn’t specify the scope or targets of any retaliatory levies.
The net impact of a tariff battle would be higher yearly inflation in Canada, according to 14 of 15 economists who answered a question on the topic in a Bloomberg survey conducted from Dec. 3 to Dec. 6. That would leave Macklem in a difficult position as the playbook for stagflation — a period of a sluggish or shrinking economy with rising price pressures — isn’t clear.
As for the central bank’s best response to a trade war, five of 14 economists who answered the question said it should bring interest rates to stimulative levels. Three said policymakers should keep borrowing costs in the neutral range, while two said pausing was the best course of action. One said moving to restrictive rates was the best approach, and three others offered alternative suggestions.
Still, the tariff threats are likely already affecting the economy. Consumer confidence was rising steadily before Trump’s election, but has reversed course — expectations are at the lowest level in a year. Ten of 15 economists in the survey said Trump’s threat will have “some impact” on business investment, with another five expecting “significant impact.”
Canada’s economy isn’t rapidly deteriorating, but growth is weak. Despite solid household spending driven largely by population growth, the economy grew just 1% in the third quarter, below the bank’s estimates, as investment and inventories dragged. While housing activity has started to rebound and there’s no signs of widespread job losses, there’s plenty of slack in the labor market — the unemployment rate jumped 0.3 percentage points to 6.8% in November, the highest level since the Covid-19 period.
The Bank of Canada’s rate path is now expected to diverge from that of the Federal Reserve, and the year-ahead spread between the expected policy rates is 119 basis points. That’s helped to push the loonie to trade at the lowest level against the greenback since 2020.
Analysts are split on whether Macklem has started to push policy too far from its southern neighbor. In the survey, eight of 15 economists say the bank and the Fed can comfortably diverge by 150 basis points or less — seven say the limit is greater than that amount. If the Bank of Canada cuts by 50 basis points on Wednesday, its policy rate will be 150 basis points below the upper bound of the Fed Funds rate.
Economists now see the central bank cutting rates to as low as 2.25% this cycle, 75 basis points lower than in an August survey.
--With assistance from Dana Morgan and Jay Zhao-Murray.
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