Stephen Meurice: It may not be February yet, but it's feeling a bit like Groundhog Day.
Tiff Macklem at press conference: Today we maintained our policy interest rate at 5%. We are also continuing our policy of quantitative tightening.
SM: That’s Bank of Canada Governor, Tiff Macklem at a press conference on Wednesday. Another rate announcement, another rate hold. One that was widely expected. But even though the central bank’s interest rate has stayed the same since mid-summer... Canada and the world’s economic landscape is still in flux. Here today as always to break it all down is Scotiabank’s Chief Economist, Jean-François Perrault. He’ll tell Armina Ligaya what he makes of the decision, but also read between the lines of what was said in the announcement and what that may tell us about when rates could start to go down. He’ll also give us his take on what the economy looks like so far in 2024.
I’m Stephen Meurice and this is Perspectives. Now, here’s Armina Ligaya.
AL: JF, thanks for joining us once again.
JFP: It's a pleasure.
AL: I just wanted to mention, before we get started, actually, that this is our 100th episode, so we're really happy that you could be a part of it.
JFP: A century, my goodness.
AL: Yeah. So you've seen the movie Groundhog Day, right?
JFP: I have seen the movie Groundhog Day.
AL: I think you can tell where I'm going with this because we have had this conversation quite a few times. We just did an episode on this in December on the last rate decision. So are we basically in the same place we were, or has something actually changed this time?
JFP: I think we're pretty well in the same place that we were. We certainly are going to change our views as a result of the Bank of Canada decision. It's been clear to us for a while that rates were going to go down – at least we were hoping that rates are going to go down sometime in 2024. And the governor on Wednesday indicated that that seemed to be his line of thinking as well. It's just a matter of when that might occur and the speed at which it occurs once it actually starts to go.
AL: Mm hmm. So, you know, from the actual decision itself was not a surprise, obviously. But all eyes are looking at every statement, every word in the press conference for clues. What stood out to you? What is the big takeaway from Wednesday's announcement?
JFP: Well, it's honestly, it's a little bit difficult to take a big takeaway out of it because it was so expected. You know, there's a little bit of surprise in that in previous statements, the governor had indicated in the monetary policy statement that they would possibly raise rates if needed going forward if inflation didn't behave. So they took that out. But then he mentioned that in his press conference. So it's one of those things – did they really take it out if he feels the need to say it afterwards. So there wasn't really anything that came out of that. It was like, oh my goodness, this there's something unexpected coming out of the Bank of Canada these days.
AL: Mm hmm. There's one comment from the statement that stood out to me: “If new developments push inflation higher, we may still need to raise rates. But what it does mean is that if the economy evolves broadly in line with the projection we published today, I expect future discussions will be about how long we maintain the policy rate at 5%.” So, further to what you said, is this the first time that Tiff Macklem was explicit about that?
JFP: Yeah, it is. It is. I mean, it's not a surprise that he is that way. But that's kind of mainstream economic thinking now. Almost certainly the next decision is going to be a cut. And that's been true for quite a few months now. It's just a matter of when that cut takes place. And the governor, I think, kind of confirmed that he's thinking along those lines as well today.
AL: So since the last time we spoke, December inflation numbers came out and it went up a little bit, surprisingly, to 3.4%. So how did that factor into the Bank of Canada's decision today, or how should that have factored as well into the Bank of Canada’s decision?
JFP: Well, I mean, coming back to the Groundhog Day decision, Groundhog Day. This is effectively a repeat of what occurred at the last meeting where it's clear the economy is slowing. There's no question about that. And the governor has been very clear that he's seeing that. And that's actually comforting because it means monetary policy is having an impact. So they know now that they've hit a level where growth is slowing. So that's, again, not comforting for Canadians, but it's comforting for a central bank governor who's trying to slow things down. Unfortunately, inflation isn't slowing down at the same pace that economic activity is. We've seen in the most recent inflation numbers and underlying measure inflation – so when you strip out the really volatile stuff, so you get a sense of the trend of inflation – that actually accelerated in the month of December. So it went in the other direction as to what was hoped for. So the challenge for the governor, as is the challenge for forecasters, is trying to reconcile the slowdown in economic activity with an as yet to be observed in any meaningful way slow down in kind of trend inflation. And that's really going to be things that folks watch over the next several months to figure out when the Bank of Canada is going to cut. Is inflation eventually going to start to come down? Underlying measures of inflation slow down? Is wage growth going to slow down? Is our inflation expectation going to change? All those things are going to be critical to figuring out the precise moment for which the Bank of Canada will eventually, hopefully cut rates.
AL: Why has inflation been so stubborn? Earlier on, with the rate cutting cycle, you'd see a bit more progress. But now it seems to be tapering off or in fact, actually going up a little bit. So what's going on there? Is it just –
JFP: We're not 100% sure. Like we know things like shelter have gone up a lot, but that's taken out of underlying measures of inflation. So you got to think of a kind of a deeper mechanism there. So part of that is there still is pent up demand for certain things. Auto sales have been very strong, for instance, last couple of months because we know the people have been waiting for cars to come in. So firms have got pricing power. So they've been able to benefit from that to some extent. So we know there are pockets of that here and there. Inventories are at a better level, but it's probably got something to do with wages, and wages are rising very rapidly and productivity is very low, in fact, declining. And that combination of strong wage growth anywhere, you know, in the 4 to 6% range, depending on the wage measure you're looking at with, again, falling productivity means that it's very difficult for firms to manage the wage increase without passing some of that on to end users and buyers of stuff. So that's probably underlying some of the strength inflation that we've seen this kind of dynamism on the wage front, married with this horrible productivity performance. And we're seeing that play out in real time in terms of inflation being a little bit more stubborn at current levels than it should be, than we want it to be.
AL: Are there other factors that are also playing into that? For example, we've talked about this before, geopolitical conflict, which seems to also be heightening and also more recently, attacks in the Red Sea affecting trade routes. Are those factoring into this?
JFP: So I don’t think those are factoring into inflation yet. They will eventually affect inflation if they're maintained. So as we think about the inflation path for the next several months, we continue to be of the view that risks are tailored to the upside. That is to say that inflation is more likely to surprise on the upside rather than on the downside. And that's again partly because of this wage and productivity issue, but more recently because of the conflict in the Red Sea and the interruption in shipping traffic and the interruption in supply chains that results from that and the increased costs of shipping, which are almost 200 basis – 200% in the space of a couple of weeks, three or four weeks. Those are all inflationary. Now, it depends on how lasting that is and if it reverses quickly, which doesn't seem to be the case, but that might happen. So there's an accumulation of things as we kind of look out the window that suggests to us that the risk on the inflation side, again, are tilted on the upside and some of those risks are materializing. We didn't, for instance, think there would be kind of the interruption in shipping a few weeks ago. That is a story now as we're reflecting that. But it is an environment where because inflation is still high, because people are still hoping or wanting inflation to come down, the stakes are really high. So any little thing that pushes inflation in the wrong direction is really meaningful. And the governor actually talked about that, said, listen, inflation is not where you want it to be and we will overweigh risk to the upside of inflation. I'm more worried about upside risks in inflation than I will be about downside risk inflation.
AL: Mm hmm. How about housing? Obviously, that's especially with mortgages, that's very much a factor here. But is a potential surge in housing prices or a surge in housing demand now that there seems to be a sense that rates are on the way down, could that also put pressure on it?
JFP: It could. It could. I mean, we know housing is adding inflationary pressures one way or the other. Rents are going up very rapidly. Mortgage interest costs are going up very rapidly. Those are things that are taken out of these kind of trend measures of inflation, because they're so much more rapid than other indicators of inflation, other measures of inflation, that you just strip those out to get a sense of the trend. But we know actually one of the surprises in December was the housing market turned around pretty quickly and there's a concern there. And part of that is, of course, because folks expect rates to come down. So there's a concern as you get into this year that this expectation that rates are going to come down. Obviously, this very large gap between supply and demand, which is only getting larger as time goes by, that those two things interact with and generate a bit of a rebound in the housing market sooner than perhaps the Bank of Canada would want. That would be inflationary. It would add pressure to prices, of course, make rents more expensive too. But maybe more importantly, it creates economic activity. And the governor's been very clear that he expects three or four quarters of flat growth. And if that doesn't happen because the housing market picks up, because people expect lower interest rates, that will throw a wrench in the rate cutting plans as well. So not necessarily inflationary, but it blunts the disinflationary impact of weaker growth if growth is not as weak.
AL: Mm hmm. What other factors are you and the Bank of Canada watching closely to sort of determine what to do for the next rate decision?
JFP: Well, listen, the governor kind of identified a few things. He said, looking at wages, obviously, looking at underlying measures of inflation, looking at pricing behavior on the part of firms and looking at inflation expectations. So he's basically laid out a road map like I want to see improvement on all these things before I'm comfortable enough with the inflation environment for me to do something about that. Mm hmm. So obviously, wages top of that top of that list, they're expanding extremely rapidly. Great for workers and also great for businesses. And it's inflationary. So we'll see. We'll look to a softening in wage growth as we go forward. We expect inflation expectations to improve as inflation does come down. So there's a range of things that are there. But I'd say like the single most important thing apart, of course, from the inflation measures themselves would be what's going on labour markets and the wage side.
AL: Mm hmm. Later this month, we'll be getting the latest GDP numbers. What are you expecting there and how would that affect think the Bank of Canada's next decision?
JFP: Yeah. So we're expecting GDP for the fourth quarter. We're expecting a little bit of growth around half a percentage point. Again, we know the economy is weakening and half a percentage point is not strong growth by any stretch of the imagination. So that's reflecting some weakness. We're hoping that it doesn't come in stronger than that. And there is evidence that suggests that maybe that might be the case. Holiday sales are stronger than people anticipated. Car sales picked up in the second half of the quarter. Housing market picked up in December. So it's possible that we have a bit more strength than we'd want in the fourth quarter. And if that were to be the case, that reduces the disinflationary pressures that that we think are there and that's a concern. So it's an environment, of course, we want growth to be strong. Everybody wants to see that. But in the current environment, strong growth actually impedes the Bank of Canada’s efforts to slow economic activity to 2% inflation and imperils to some extent the possibility of lower rates.
AL: In terms of recession risk, you're saying that it's not very strong, but not possibly could have more strength just from a recession risk perspective. Are we out of the woods of that or is there a potential soft landing that everyone had been sought after actually happening here?
JFP: I mean, the more the more time passes, the more data we get, the more likely, the more comfortable we are with a soft landing scenario. And that's simply a scenario where kind of growth stalls for a little bit and inflation gradually comes down. So it's not a hard landing. It's not hundreds of thousands of Canadians losing their jobs and a broad based decline in economic activity. But there's a risk. There's a risk that we do go through that. There's no question about it. The economy is slowing. It's difficult to calibrate policy exactly right so you get exactly the right amount of slowdown that you'd want. So there's a fear out there that we still might see a more meaningful slowdown in the short run. And of course, if that were to happen that probably means a little bit less inflationary pressure. And it might mean that the Bank of Canada would have to cut sooner rather than later or maybe more than we currently expect. And that's not what we expect. The surprising thing has been resilience on the household side. So spending has been stronger than we anticipated. Slowing but not slowing as much as we thought. So all the evidence kind of is accumulating suggests that we're probably not in for a hard landing, a proper recession. But you can't rule it out.
AL: And then, meanwhile, south of the border, the U.S. economy has actually been doing pretty well.
JFP: Very well.
AL: And so I guess given the obvious trade relationship between Canada and the U.S., how does that factor into both the performance of our economy but also the Bank of Canada's decision?
JFP: Well a strong U.S., of course, helps Canada and helps the world. So that is in some sense a headwind to lower inflation, a minor headwind, but a headwind nonetheless. That being said U.S. inflation is coming down a little more rapidly than Canadian inflation is. So to the extent that we import stuff from the Americans and their price levels are moderating a little more rapidly, that kind of helps inflation on our end be a little bit better behaved. But there's no question that the strength in the U.S. economy is a tailwind for us. It gives us a bit of a boost. We don't necessarily need that boost right now. But that's just the nature of the beast. The U.S. is doing very, very well, much better than anybody anticipated.
AL: Now, I'm curious, why is there is coming down faster?
JFP: Well, inflation, yes, is coming down faster. We're not 100% sure why, but it's probably got something to do with productivity. So coming back to the wages and productivity questions on Canada, we've had a decline in productivity levels. The U.S. has seen an explosion in productivity growth in the second half of 2023, which means that in very simple terms, it's much easier for firms to incorporate higher wage growth when they're more productive than when they're not. So it makes it easier for them to absorb that wage increase relative to Canadian firms who are seeing productivity levels decline and are confronted with a similar amount of wage pressure. They're more inclined to raise prices because they can't they don't have the flexibility to absorb as much as American firms do.
AL: Mm hmm. Does the Fed's decision, which is coming up as well, will that have an impact on what the Bank of Canada does?
JFP: We don't think so. Our current forecast is that both the Fed and the Bank of Canada move in the month of June. So a week apart from each other. It's possible the Fed moves a little bit sooner. I mean, it's not our view, but it could happen. We think it's very unlikely that the Bank of Canada moves sooner. And that's basically because each central bank is going to set policy in line with what's going on in inflation world in those countries. And in Canada, the inflation situation I think is a little bit more problematic than it is in the U.S. So even if the Fed ends up cutting more or more rapidly than us. I don't think it means that the Bank of Canada is going to have to follow that in any meaningful way. In fact, we don't think they're going to do that.
AL: Mm hmm. It sounds like a lot of factors that need to sort of come together for to set the stage for rate cuts. So you mentioned June. I think that's still the target you had last time we spoke. Is that still the case or are you still thinking that's the case but there's a little bit more wiggle room than there would have been before?
JFP: We're still thinking that's the case, but it's a case that's getting harder and harder to defend. Because, as you said, these risks on the inflation front are accumulating. And, you know, if anything, if somebody were to force put a gun to my head, say, “Change your inflation forecast, change your rate forecast,” we would push it out. So not the June meeting, one of the meetings afterwards and maybe end up doing less in 2024 than we currently anticipate. And we're not changing that forecast. But the balance of risks is kind of shifting in a way that makes it a little bit more difficult to argue that June is the right date.
AL: Mm hmm. So if you're a mortgage holder or even a would be home buyer, what should you take away from all this, particularly the 2 million or so in Canada, who should be renewing in the next couple of years?
JFP: Well, I mean, we're talking at the kind of at the margins of a rate forecast here. So it's pretty clear that rates are going to be lower this time next year, I guess this time in 2025, than they are now. So that we’re very, very confident about and I think most people are very, very confident about that. So it might happen a little bit later than you otherwise would think. But at the end of the day, folks should expect significantly lower mortgage rates as the year progresses. And we've already seen some of that in the fixed rate space where five year mortgage rates have come down a fair amount. That's probably going to continue. It's just a matter of waiting for those variable rate mortgages to also experience some kind of decline in price. And again, pretty confident it's going to be this year. So I think people should expect that.
AL: Okay. So what are the big three takeaways for Canadians from the decision on Wednesday?
JFP: Well, it kind of solidifies that the governor is thinking that he's going to be cutting rates this year. So that's, I think, a very important takeaway for Canadians. At the same time, I don't think folks can rule out the possibility that those rate cuts don't occur as soon as we'd like them to be. There is a risk that that takes a little bit longer than we'd want. And a third is folks, of course, in line with that, people should expect to pay less for mortgages and kind of various debt products as the year progresses. That is a consequence of lower rates. And that seems like a pretty – not a certainty, but a pretty close to certain development.
AL: Hmm. Well, I think we'll leave it there. JF, thanks, as always, for stopping by.
JFP: Oh, thank you.
AL: I've been speaking with Jean-François Perrault, the Chief Economist at Scotiabank.
