Macro Signposts | 18 October 2024

This week, I asked economists Allison Boxer and Graeme Westwood to coauthor Macro Signposts and analyze risks facing Canada's economy.

Unless explicitly stated, views expressed do not constitute official PIMCO views.

Diverging Rate Paths for the Federal Reserve and Bank of Canada

By Allison Boxer, Graeme Westwood, and Tiffany Wilding

In the lead-up to the Federal Reserve's rate cut in September, Fed policymakers shifted priorities from inflation to employment risks, but the recently robust U.S. economic data has since moderated expectations for the speed of further rate cuts.

In contrast, the Bank of Canada (BOC) cut its policy rate in June and is poised to pursue further easing in response to a deepening economic slump. It faces below-target inflation and the largest rise in unemployment among G7 nations, potentially leading to a below-neutral policy level.

This suggests that the BOC is set to implement more aggressive rate cuts than the Fed. If so, we could see widening spreads between Canadian and U.S. bonds, with the Canadian dollar facing further pressure.

A time to pivot or a time to panic?
Three key reasons explain why the BOC needs to cut rates more quickly than the Fed and other G7 central banks.

• Economic activity has weakened materially. Despite avoiding a recession, Canada is grappling with excess economic slack, reflected in an output gap of -1.2% to -2.8% at the end of the first quarter. This is because an elevated pace of immigration has supported growth, as per capita GDP has fallen by over 2 percentage points (ppts) in the past year, marking the weakest pace this century outside of the 2008 global financial crisis and the COVID-19 pandemic.
• Labor markets have weakened. Canada's unemployment rate has risen by 0.9 ppts over the past year, while its participation rate has dropped by 0.7 ppts. In comparison, the unemployment rate in the U.S. increased by only 0.3 ppts while the participation rate slid by 0.1 ppts.
• Inflation is undershooting the BOC's target of 2%, the midpoint of an inflation-control target range of 1% to 3% annually. Headline Canadian inflation fell below target in August and dropped further to 1.6% in September relative to a year ago, compared with 2.4% in the U.S. over the same period. Canada's inflation measurement differs from that of other developed market counterparts, as its headline Consumer Price Index (CPI) includes mortgage interest costs, which can counterintuitively create an inflationary impact from prior monetary policy tightening as mortgages reset at higher rates. Absent this outlier component, Canadian inflation is a tepid 1%, barely in the target range. Additionally, BOC surveys suggest that inflation expectations have also fallen to levels broadly consistent with the BOC's target range.

The path ahead
We see few catalysts to ignite Canadian growth. Lower immigration, weaker pass-through from lower rates, limited fiscal policy support, and a muted global growth backdrop are all likely to keep the Canadian economy stagnating.

Lower immigration is likely to weigh on both supply and demand, but it should have a net disinflationary impact on CPI, primarily due to easing pressure on rent inflation.

In addition, the preponderance of five-year mortgages in Canada means that lower interest rates will likely offer a more limited boost to growth for now. Even as the BOC cuts its policy rate, homeowners who took out mortgages at low interest rates in 2020 and 2021 face renewals at higher rates in the coming years. In May, the BOC estimated five-year fixed-rate mortgage holders would see a 26% median increase in payments by 2026, and a 62% increase for households with variable-rate fixed payment mortgages.

We expect Canada's output gap will be around -1.5% in the third quarter, a level comparable to that seen during the severe oil price correction of 2015-2016. At that time, core inflation averaged around the BOC's 2% target level, but importantly, the policy rate had been lowered to just 0.5% (275 basis points (bps) below the midpoint of its estimated neutral policy rate at the time of 2.75%-3.75%.) In comparison, the current policy rate of 4.25% is 150 bps above the midpoint of the BOC's current 2.25%-3.25% estimated neutral rate range. It's a long way down to neutral, and the BOC may need to reach below neutral to stave off a significant undershoot of its inflation target amid further weakening of the economy.

Degree of divergence
The need for the BOC to lower the policy rate to an outright accommodative stance stands in contrast to the Fed, where median projections show most Fed officials don't expect to reach a neutral monetary policy stance until 2026.

How much can the BOC feasibly diverge from the Fed? BOC Governor Tiff Macklem has said the Canadian dollar's (CAD) flexible exchange rate allows the bank to respond to domestic conditions and not be tied to policy decisions of other central banks. However, some observers have raised concerns that a rate divergence beyond the historical average of about 100 bps would lead to CAD depreciation and a subsequent increase in inflation.

In our view, the implications of a potential CAD depreciation aren't straightforward. According to the OECD, 80% of Canada's consumption is derived from domestic sources. This limits the impact of a weaker exchange rate to a relatively small share of the CPI basket. BOC research likewise suggests that a 10% depreciation in the Canadian dollar leads to just a 0.3 ppt increase in core inflation after a year. Given growing worry about Canadian inflation undershooting its target, policymakers may welcome modestly higher inflation due to a weakening currency.

Investment implications
The Canadian economic backdrop suggests the Bank of Canada is likely to cut faster and deeper than the Federal Reserve. While there are limits to how far the two central banks are likely to diverge, in our view, BOC policymakers should have the confidence to respond resolutely to domestic conditions. If we see these monetary paths diverge, then spreads between Canadian and U.S. bonds are likely to become increasingly negative, while the Canadian dollar could come under further pressure, especially in the absence of any demand-driven rebound in oil prices.

Catch up on recent editions of Macro Signposts:

• Cyclical Outlook Takeaways: Securing the Soft Landing | 9 October 2024
• Does the U.S. Consumer Have Room to Run? | 2 October 2024
  
• What's Behind the Fed's Bold Move? | 24 September 2024
  
• U.S. Presidential Election: Toss-Up in Swing States | 17 September 2024
• Could We Ever Go Back to 2019? | 10 September 2024

We welcome your questions about the global macro landscape. Don't hesitate to suggest themes or data for us to analyze and discuss: Please email [email protected].

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