Canada’s central bank did something it hasn’t done in a while—nothing. The Bank of Canada (BoC) held its key policy rate at this morning’s monetary policy announcement. It was the first time in a year that rates weren’t slashed, and follows the most aggressive easing cycle since the Global Financial Crisis. The BoC held primarily due to uncertainty over the country’s path forward, as the trade war can plunge Canadians into a deep recession… or not.
Bank of Canada Holds Rates For The First Time In A Year
The BoC held rates after executing a somewhat controversial cut last month. Canada’s overnight rate remains at 2.75%, after the first hold in a year. Over the past year, the central bank had been slashing rates at the fastest pace since the months preceding the Global Financial Crisis. The BoC justified the decision by citing its expectations of slowing inflation pressures, and economic uncertainty that requires a more data-dependent approach.
Inflation pressures are plummeting with the elimination of the carbon tax and a narrowing output gap. Starting April 1st, Canada’s Liberals eliminated the Carbon Tax they had implemented just a few years prior. The BoC estimates this will remove 0.7 points from CPI—more than a third of its target inflation rate. It’s unclear how the Carbon Tax, which the Liberal Party claimed had no impact on inflation, lowers inflation when eliminated, but I digress.
The output gap, the difference between an economy’s output and its potential, also narrowed. Canada’s central bank estimates a gap of -1% to 0% in Q1, indicating the country is nearing peak efficiency. It becomes inflationary once it breaches 0%, and monetary stimulus would likely drive it above this point.
Bank of Canada Uncertain About Tariff Impact, Presents 2 Scenarios
The public finally has something in common with the BoC—fear over the impact of the trade war. The uncertainty around how it plays out has led the central bank to model two scenarios. The first scenario assumes the impact is “limited in scope,” resulting in 0% GDP growth in Q2. A second scenario assumes an average of 12% on Canada and Mexico, and 25% on other countries. In the latter scenario, they see the global tariffs triggering a four-quarter recession.
“That’s a bit more pessimistic than our assumptions, and thus is a weaker outcome than our below-consensus call,” explains BMO Chief Economist Douglas Porter.
BMO’s forecast for the second quarter sees a much more serious contraction for the economy. However, their total outlook makes the BoC’s outlook appear excessively bearish on the impact. “The Bank’s view is that in the harsher trade war second scenario, inflation would bounce back up to 2.7% next year, versus 2.0% in the milder outlook—again, we lean lower on where inflation will ultimately settle in such a challenging economic backdrop,” adds Porter.
Tariffs will initially be inflationary but higher prices reduce consumption, and thus inflation. The reduced consumption will apply downwar pressure on inflation, requiring monetary stimulus to bolster CPI into the target rate. If the trade war doesn’t resolve amicably and fast, interest rates are likely to come down further.
BMO reiterated its expectations of three more rate cuts this year. The overnight rate would end the year at 2.0%, below the neutral policy rate. Below the neutral rate means the central bank will be applying inflationary stimulus to bolster demand, and raise prices. Before rushing out to speculate on rate-sensitive assets, it’s worth understanding the outlook is only as certain as the market’s beliefs.
Market forecasts are a snapshot of current information. The trade war uncertainties mean information can be volatile, impacting the underlying assumptions in the forecast. Even the central bank’s promise to become data-dependent is a strong sign that they also have no clue what’s coming.
“There’s not much sense parsing every word from the Bank when the economic landscape can shift so abruptly in coming weeks, and the Bank—like the rest of us—will be reacting and responding to those shifts. We believe that the deep trade uncertainty will weigh heavily on growth in Q2 and Q3, blunting inflation pressures, and eventually prompting the Bank to trim rates further, ultimately taking them slightly below neutral—which would be entirely appropriate in a world of trade trauma,” warns Porter.
