Rates To Keep Falling (If Spending Doesn’t Rebound): Scotiabank’s Forecast Tables

• The Bank of Canada and Federal Reserve should cut policy rates at each meeting for the remainder of the year and well into 2025.

• Growth is slowing as the impact of past tightening is felt but we expect a gradual strengthening of economic activity as policy rates come down. North American central bankers seem, at this point, to have achieved a soft landing.

• We remain concerned about potential upside risks to household spending given high savings rates and accumulated savings, solid income growth, the massive gap between supply and demand in the housing market, and historically strong population growth. We assume a gradual improvement in spending but a larger or more rapid rebound in spending could imperil Bank of Canada cuts in mid-2025.

• The usual disclaimer applies: US election outcomes could lead to significant changes to this outlook.

The path forward for interest rates keeps getting clearer. With inflation and growth cooling owing in part to the lagged impacts of monetary policy, central bankers in Canada and the US seem confident in their assessment that interest rates will be cut substantially in coming months. The key questioning surrounding policy rates is the speed at which rates will decline, not whether they will decline from here. Key to that assessment is a view on growth dynamics, inflation, and risks to both. Though growth is weakening in both countries, we believe economies are landing softly and will not require central banks to act in an urgent way to shore up growth. As a result, we expect a gradual pace of cuts in Canada and the US, with two more cuts in Canada this year and three cuts in the US. A multitude of risks exist and while markets and most economists appear to prioritize downside risks to the outlook and interest rates, we continue to believe there are meaningful upside risks to both.

Focusing on Canada first, there are clear signs of softening in the economy. This is a welcome sign for the Bank of Canada as this softness is largely engineered. High policy rates are impacting the economy. The data are tricky to analyze, however. Though second quarter growth was stronger than expected, much of that strength came from the public sector (which includes educational and health services). Households continued to build savings as disposable income growth continued to far outpace spending. Auto sales have picked up as interest rates have fallen, but the housing market has not yet responded to lower borrowing costs in a meaningful way. The labour market has cooled but continues to generate very strong wage gains despite a sizeable increase in the unemployment rate over the last year.  That rise in the unemployment rate to a large degree reflects the surge in population we have observed over the last year. That population surge, on the other hand, continues to support consumption, depress productivity in the short-run, and has widened the gap between supply and demand in the housing market.

The greater question on our minds is the responsiveness of the economy to lower interest rates. Falling borrowing costs will clearly boost demand but there are doubts about the extent, and perhaps most importantly the speed at which this may happen. Our model suggests sizeable pent-up demand for housing, investment and consumption. It also suggests that this pent-up demand will resolve itself gradually over coming quarters. This is what we have reflected in our forecast and why we expect growth of 1.1% this year and 1.9% next year. There is a risk however, that this pent-up demand is larger and/or closes more rapidly than history would suggest. Two data points in particular are relevant in this respect. The accumulation of excess savings, which now stand around $470 billion, and the personal savings rate, which is above 7% (charts 1 and 2). The savings rate is at the highest level since the mid-1990s if we exclude the pandemic period. Add to that the clear gap between housing supply and demand and there is a risk that lower rates prompt a more rapid return of household spending and residential investment. That risk would be more acute around the spring housing market. This remains a risk at this point, but a sharper rebound in household spending than currently expected would dampen disinflationary pressures and could force the Bank of Canada to cut less than currently expected in 2025. As it stands, we forecast that Governor Macklem will cut interest rates to 3.0% by mid-2025.

One thing that is important for borrowers to consider is that the prospect for lower longer-term interest rates is slim. The yield on 5-year Government of Canada bonds is around 2.8% at the time of writing. These longer-term interest rates already build in the expected decline in policy rates on both sides of the border. From a potential homebuyer perspective, we would not expect much lower 5-year rates going forward and indeed our forecast is for those rates to drift up as markets price in a proper term premium into the yield curve.  The decline in borrowing costs will be much more concentrated in shorter maturities, and in prime lending rates.

In the United States, we now expect the Federal Reserve will cut interest rates by 75bps through the remainder of this year and for the policy rate to fall to 3.5% by mid-2025. We do not believe the US is in recession nor is it likely to be in one. Economic indicators remain generally solid though there are clearly signs of softening. These are most evident in the employment market. Household spending remains reasonably strong as does the service side of the US economy. At this time we think that Chairman Powell and company should pursue a series of gradual cuts.

Our views will be impacted by the US election that remains too close to call. The outcome of that election could be of significant consequence to the global economy and markets but given how close the polls indicate the election is, we will only reflect the outcomes of the election once the victor is known along with the composition of Congress.