FLCA - BOC's Hawkish Hold: Threading The Needle Between Softer Growth And Sticky Inflation

2023-10-26 20:18:00 ET

Summary

• Why the BOC still needs a hawkish tone.
• Canadian inflation remains persistent, even as growth slows.
• Why a BOC rate cut may not come until Q4 of 2024.

The Bank of Canada kept its overnight rate on hold, but also warned about persistent inflation, even as economic growth slows. Andrew Kelvin, Head of Canadian and Global Rates Strategy at TD Securities, discusses the latest rate decision and the BOC's strategy with Greg Bonnell.

Transcript

Greg Bonnell: The Bank of Canada held its trend-setting rate steady at 5%, but they're also saying they're prepared to hike rates again amid slow progress in the fight against inflation. Joining us now to unpack it all, Andrew Kelvin, Head of Canadian and Global Rate Strategy at TD Securities. Andrew, great to have you back on the program.

Andrew Kelvin: Thank you for having me. Always a pleasure.

Greg Bonnell: All right, so we got the hawkish hold, which was the expectation, but some, I guess, changes from the Bank of Canada in terms of how they're seeing this fight going forward on the economic front, the inflation front. Break it all down for us.

Andrew Kelvin: It was a pretty interesting meeting, even if it wasn't surprising. The needle the Bank of Canada had to thread was a trade-off between growth that had been quite a bit weaker than anticipated and inflation that had been quite a bit more persistent than anticipated, if you go back to their forecast from July.

So I think to the extent that there were questions about what would happen, it wasn't around what would happen with the overnight rate. I think looking for rate hikes always sort of felt like a long shot. But it was about what they would put more emphasis on. And it does look like, while they tried to address both sides of the argument, they did put a little bit more emphasis on the slowing demand environment.

I think the Bank of Canada would very much like to be done with rate hikes here. They talked about giving rate hikes time to work their way through the economy. At the same time, it's important for the Bank of Canada to let Canadians know that they remain vigilant in order to keep financial conditions relatively tight, because if they tell us they're done or that they think they're done or that they'd like to be done, without forcing us to read between the lines, markets react. And it becomes counterproductive for them.

So while the Bank of Canada did warn that inflation has been coming down more slowly than they'd hoped, perhaps, that inflation, the inflationary backdrop, is still high, and they need to see more progress on the inflationary trends, it did strike a fairly comfortable note in the context of seeing that large upside revision to their near-term inflation forecasts.

When I take a look through the statement and talking about a new source of geopolitical uncertainty -- of course, this is what's happening in the Middle East -- what it could mean for the price of oil, are they sort of in a situation now where they see things progressing in a certain way, although slower than they first saw it, but there are always wild cards?

Andrew Kelvin: Yeah, and I think one of the messages they wanted to get across is that the uncertainty is higher than it normally would be, because there's always wild cards. There's always uncertainty in the economy. I think the message they're trying to put out is, one, that there's more uncertainty than normal.

And two, that because inflation has been high for a number of years now, they need to be a bit more vigilant against inflation. I think that was part of their message. And that's part of the reason why they continue to talk to the idea about inflationary risks having risen simply because inflation hasn't come down to the extent they would have hoped or expected so far.

Greg Bonnell: Now, with this fight taking longer than expected, taking longer to get back to 2%, a weaker economy next year, one of the headlines I saw moving across the wires was Tiff Macklem saying there's a narrow path now for a soft landing. Everyone's been talking, well, how does the economy resolve itself out of this? Maybe we just keep going on, or maybe we have a nice soft landing. Is it because this fight is taking longer than expected that that path is quite narrow now?

Andrew Kelvin: I think the fact that the Bank of Canada was a little bit slow off the mark last year always implied a very narrow path for a soft landing. So it meant that they now had to start tightening in leaps and bounds, instead of just very gradually tightening.

The fact that there is a sort of narrow path, it also says that Canadians are very highly indebted. And because inflation has been very persistent, we're having to keep sort of a high for longer sort of a scenario. It won't be a quick move to 5% and then a quick return to a somewhat easier policy rate.

And Governor Macklem did actually address that in the press conference, stating that it's far too early to be talking about rate cuts. The longer we are at 5%, the narrower the path for a soft landing becomes. And a soft landing, it becomes a little bit of an argument about semantics, on some level. I mean, the Bank of Canada is looking for growth to be 0.8% annualized this quarter, 0.8% annualized next quarter, which is, in real terms, unannualized terms, just slightly above zero, in the context of very robust population growth.

So the Bank of Canada is talking about quite negative per capita GDP growth, but I guess we've all sort of agreed on this idea that a soft landing is one where the aggregate economy doesn't shrink. So that's still, I think, in play. But when you start talking about two consecutive quarters of growth below 1 coming off of a quarter which was very marginally, modestly negative, yeah, it's a pretty narrow dividing line between what you would call a soft landing and what you might call a harder one.

Greg Bonnell: So you mentioned Mr. Macklem saying that it's too early to talk about rate cuts. Of course, investors do ask that question. He was asked the question. At this point, is it a bit of a tough game to try to figure out when a cut might finally arrive if it's taking this long to get inflation under control?

Andrew Kelvin: And that's exactly it. It's how long does it take to get inflation under control. For the BoC to cut rates, four things need to be true, two of which can be achieved pretty easily, two of which could be a little bit more difficult. So the first two things we need to see happen for the BoC to cut rates credibly, we need to be in excess supply. So we need to have some slack in the economy. The Bank of Canada thinks we might be there now.

We need to see growth below trend. Bank of Canada believes growth to be below trend in the current quarter, in the previous quarter, and the quarter before that. So those two things have already been sort of checked off.

And in a cycle where we hadn't had two-plus years of well-above-target inflation, we might be talking about cuts now. But in an environment where three-month annualized core inflation, which is sort of a nice measure of your underlying trend, where that's running at about 3.7%, and where headline inflation is still well above the 2% target, as well -- it's currently about 3.8%, as of the last reading -- that's a world where it's very difficult to credibly cut rates when you're an inflation target who has been missing your target.

So for the BoC to talk about cutting rates, they need to be on a very firm and clear path to the 2% inflation target. We don't need to be there in terms of year-over-year inflation, but the sort of like higher frequency, three-month inflationary trends need to be pointing at 2%. And that's where it looks like there's still quite a bit of ground to cover. So we have rate cuts in our forecast in the third quarter of next year. And it really is just a question of the speed with which inflation normalizes.

Greg Bonnell: Now, with the Bank of Canada having giving us its decision this morning, its commentary about the economy, the clock is ticking toward the Fed on November 1. What should we expect from that central bank, arguably the most influential one in the world?

Andrew Kelvin: Absolutely the most influential one in the world. As much as I would like to put the Bank of Canada on the same level, it is not.

So the Fed's sort of an interesting one because they're looking at sort of a very different set of shocks. Whereas Canada has been characterized by very soft growth, unexpectedly soft growth in the third quarter of this year, the US economy looked like it was quite strong in the third quarter. So the Fed is sort of confronting this fairly robust growth outlook while seeing improvement on the inflation front.

The Fed did leave the door open in its last meeting to one more rate hike this cycle, with the majority of participants suggesting it could be this year. I don't think this is a story for this upcoming meeting. They are going to leave the door open to certainly future tightening. And ultimately, it's going to be a very data-dependent thing.

We do expect the US economy to start slowing again in the latter part of this year, which we do think will help keep the Fed at its current policy rate. But it is something where the Fed does need to see that deterioration in the growth figures, ultimately, if it is going to justifiably be able, or comfortably be able, to hold at current levels.

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