Bank of Canada lowers the overnight rate to 3.25%

Stephen Meurice: The Bank of Canada has announced another big cut.

Tiff Macklem [at press conference]: Today, we lowered the policy interest rates by 50 basis points. This is our fifth consecutive decrease since June and brings our policy rate to 3¼%. 

SM: That’s Bank of Canada Governor Tiff Macklem at his latest press conference. 

TM: Monetary policy has worked to bring inflation back to the 2% target, our policy focus is now keeping inflation close to target.

SM: Here as always to make sense of this latest decision is Scotiabank’s Chief Economist, Jean-François Perrault. He’ll tell us what factors may have led to this decision, what it might indicate about the health of the Canadian economy, if and when we’ll see further cuts, and much more. I’m Stephen Meurice and this is Perspectives.

JF, welcome back. It's always great to see you.

Jean-François Perrault: Pleasure to be on with you again, Stephen.

SM: All right. So another 50-basis point cut from the Bank of Canada, widely anticipated by you and your team and others. What's the main headline, takeaway, what should Canadians read into this decision?

JFP: A number of things, but I think the most important thing and that was made reasonably clear by the governor during his post-decision press remarks, is that he is getting closer to the end of the tightening cycle. So there's a question as to whether or not we do another 25 basis points, 50 basis points. Some debate there. We currently have a forecast of 3%. We might change that to 2.75%, but there isn't much cutting left to do. And that reflects the fact that, as the governor indicated, they cut rates aggressively. They are starting to see some signs of traction on those rate cuts in the Canadian economy. And it's time for them to go a little bit slower than what they've what they've done and maybe even at some point pause.

SM: I want to come back to that sort of forward looking potential future cuts or not. But I guess, does this mean now that inflation is beaten? The Bank has gotten it where it wants to be for the time being now there's a pause or a slowdown in this in this rate cutting cycle?

JFP: I think it's clear they're very comfortable with where inflation has been headed. Now, the governor points to some upside risk to inflation, which are evident. And we know the job market is still generating wage increases that are well above 2%. So outside of the Bank of Canada's target. And so there's a concern there, of course, combined with lower productivity that amplifies those concerns. So there are some upside risks to inflation. Then again, there are some downside risk to inflation as well. I mean, growth has slowed to some extent and that was arguably the reason for the latest 50-basis point cut. And that poses some downside risk to the economy in the sense that if the economy continues to be slow, to be sluggish, then of course inflation might fall a little bit further than where it is now. On balance our reading of his communications suggest that they seem reasonably comfortable with where inflation and not prioritizing downside risk over upside risks. And that's one of the reasons we think that we are very near the end of the rate cutting cycle.

SM: So who are the winners now? I mean, obviously with another interest rate cut, people with variable rate mortgages are going to be happy. Tell us a little bit about who the winners are from today's decision.

JFP: Well, absolutely consumers, first and foremost, the households first and foremost. Obviously, with the cut in interest rates comes lower mortgage borrowing costs, lower line of credit costs. And we are seeing that having an impact on the economy already. In fact, one of the strengths, if you will, in the third quarter – so GDP in the third quarter is about one percentage point, not very strong. But when you look at the rate-sensitive parts of the economy, so consumption, real estate, those picked up pretty strongly. And in fact, when we look at the tracking for the most recent data, auto sales, for instance, over 2 million for the month of November. So very strong response of those rate sensitive parts of the economy as rates have come down. And we expect that to continue. So households are clearly benefiting from that in terms of their day-to-day spending decisions. Now, of course, as folks renew their mortgages, the further those variable rates come down as the Bank of Canada rate comes down, the more they benefit. Where it becomes a little bit trickier is for folks who are kind of in fixed rate mortgages. Say there's a five-year fixed mortgage, who will want a five-year fixed rate mortgage? Because even though the Bank of Canada has been cutting interest rates in the short end, there will be a normalization of what we call the yield curve as time goes by. That is to say there is usually an upward sloping yield curve. So that there's a positive difference between, say, a five-year borrowing costs and a very short run borrowing costs like the Bank of Canada's. And historically, that gap between, say, a five-year Government of Canada bond rate and the Bank of Canada rate is in the 75-basis point range. So that means that as we go forward, our expectation is that those longer-term borrowing costs – so the five-year Government of Canada borrowing costs – would go up from where they are now. 75 basis points, 50 basis points – we will see. So there is this kind of bifurcation in terms of borrowing costs as we see them going forward. Short run: cheaper and, of course, beneficial for those people that are keyed off of that. If you're thinking longer term, maybe a bit of an increase in borrowing costs, which is completely normal. That's how monetary policy works. But might be a bit of a surprise to people who think that for instance, if you want a five-year mortgage, fixed rate mortgage, that the longer you wait, the cheaper that will be. That's not necessarily the case.

SM: Okay. So we won't get too deep into the housing aspect of it or the mortgage aspect of it. But basically what you're saying is in terms of variable rate mortgages, those are impacted directly by Bank of Canada monetary policy decisions. Fixed rate mortgages are in fact determined by other things, by the bond market and so on, and are sort of inversely affected by a reduction in in the Bank of Canada's rate?

JFP: Well, they usually follow to some extent, but a resumption of normality. So when you raise interest rates, it’s a different dynamic than when you cut interest rates. But markets look at a number of years and as you get closer to the end of the cutting cycle, then markets look forward to the next five years and at some point there will be higher interest rates and they reflect upon that in in their pricing.

SM: What about business? What about the business outlook with the lower interest rate?

JFP: And it's also great for them. Right, at the end of the day, businesses sell to households. So if households are coming back into the picture, businesses eventually will follow. And of course, lower interest rates benefit businesses as well. So not just the household decision. The cost of capital is a key determinant of investment. It's a key determinant of how businesses feel about the economy. So of course, as rates come down, we would expect businesses to feel better and engage more aggressively than they have over the last year or so.

SM: So, what are the main factors that influenced this latest decision by the Bank of Canada? I mean, there were unemployment numbers that came out last week, I assume is maybe one of the factors, but what was involved here?

JFP: I mean, the governor pointed to a number of things. One is the weakness in the economy. So 1% GDP growth, now have indicated consumption grows much more rapidly than that. But at the headline level, a bit of a disappointment on the growth front there, some reflection on the unemployment rate, which has picked up meaningfully over the last year as an indication of slack in the labour market. Now, there are reasons to be cautious about that and temporary workers and those kinds of things. But there is a bit more slack in the labour market from the governor’s perspective than perhaps he would have liked. And of course, the inflation data and even though the most recent inflation report in Canada was a little bit to the stronger end of things, generally speaking, the inflationary trend in Canada has been pretty comfortable on the way down to 2%. So it's a combination of things which I think suggested to the governor that another 50-basis point cut on top of the one last time was the right thing to do. Now, he didn't seem overly confident about that. I mean there was clearly discussion as to whether he would cut by 50 versus 25, in part because those rate sensitive parts of the economy are turning around pretty significantly. And there might be upside risk of inflation. But those were the factors that he pointed to as being important for their decision.

SM: Right. And your colleague, Derek Holt pointed out that these so-called super-sized interest rate cuts traditionally tend to happen during sort of times of crisis, during the pandemic, the global economic crisis, 2008, 2009. Now we've had two of those in a row. Does that mean we're in a crisis?

JFP: I don't think so. Now, to be clear, we thought the Bank of Canada should cut by 25 basis points. They moved by 50. And one of the reasons we were cautious of them moving by more than 25 was specifically for that. Are they signaling some deeper concern about the state of the economy? Is there something that they're seeing that we're not seeing that would justify these back-to-back 50-basis point cuts? We're not seeing that. The governor doesn't seem to be seeing that as you kind of listen to what he's indicated in his press remarks, he didn't seem to be overly concerned about the state of the economy. Now, he did point to significant uncertainties related to the presidential transition in the United States and what that might mean for tariffs and the impact on Canada and inflation, which is, of course, a very significant cloud over the outlook. But that's stuff that may or may not happen. It doesn't justify kind of an emergency rate cut. So, the governor's explanation was, ‘Listen, we cut by 50 basis points. We're trying to get to a more neutral stance in monetary policy.’ So at 325, they are now in the upper range of what they consider to be a neutral interest in Canada. So, between 2.25 and 3.25. So, he's characterizing it as normalizing interest rates, not an emergency cut, just bringing things to a level that is closer to a more neutral setting rather than the setting that they had previous to that, which was still at a little bit tight monetary policy.

SM: Okay. So, coming back to sort of where you started, which is what might happen next. What did the governor indicate around their position going forward?

JFP: Well, listen, he’s always very, very cautious about what he indicates on that front. So he was very clear that he indicated that the pace at which they had been cutting will not be replicated going forward. So don't expect another 50-basis point at some point in time. So they'll go back to being more gradual, more data-dependent. Now, that could mean a pause. It could mean cutting by 25 basis points at a further distance from each other. Now, we think at least another 25 basis points of cuts is in the bag. So at least going out on a three. We're debating right now on the team as to whether or not we put a little bit more into the hands of maybe 2.75. But if you're in a world where you’re kind of fine tuning towards the end of the cutting cycle, you're not probably in a world where you're cutting every meeting for the next little while. So, the trick is going to be when do they cut for the next 25? And then if they do a little more than that, when do those things occur? Presumably they'll be done cutting by the end of the spring, one way or the other. Or early summer.

SM: Right. You talked a little bit before about sort of a fair amount of robustness on the consumer side of things, auto sales, consumer spending generally. Is there any risk of that if people suddenly start spending more as a result of lower interest rates, I mean all of which all is which is part of the program, of inflation coming back and the risk of interest rates having to go back up again?

JFP: Definitely. I mean, this is why we think the Bank of Canada should stop roughly in the 3% range, again, maybe 2.75/3. Others have got the Bank of Canada cutting significantly more than that all the way down to 2, for instance. And our thinking behind that is looking again specifically to what we see happening on the household spending side. This acceleration in spending, a likely acceleration in the housing market as we get into the spring, that those two things together can create positive surprise on the growth side, which of course would not be unwelcome given the fact that growth is reasonably weak right now. But in an environment where wage growth is still strong, the concern is that if you turbocharge that side of the economy too much and you get a little bit too much growth and maybe you're putting upward pressure on inflation as you go forward, and that's not something, of course, that the Bank of Canada would like because we are still trying to get inflation to land at 2%.

SM: Okay. You talked a little bit about some external factors, what's going on in the United States and so on. We don't know what's going to happen or what’s necessarily the impact, and I guess they don't pre-emptively make decisions around that, they’ll wait and see what's going to happen. In terms of internal factors, I mean, there's this temporary GST cut that's going to go into effect soon. Potentially these cheques going out to working Canadians, both from the federal government, some other provincial governments talking about some of the same things. What are the potential impacts of those on the economy and by extension on things like inflation and interest rates?  

JFP: It's a great question and it's a serious question because we know that over the last number of years, as governments have gone out and given checks to people and tried to help them out with higher interest rates and higher food costs by providing some financial relief, that that has actually made the Bank of Canada’s cutting job much harder. Because it's insulated the economy from the impact of higher interest rates. As we get into this year or next year, there is going to be a bit of a repetition of that. Ontario wants to give $200 to a large number of people, the federal government likely to do the same. The initial proposal was $250 to a group of people. And now that seems to be not generous enough for one of the parties. The B.C. government has campaigned on giving households basically $1,000 cheque at some point. So there is a risk that as we get into the spring and the domestic economy starts to reflect on these higher interest rates a little bit more aggressively. So stronger consumption, stronger housing, that you layer in on top of that, some financial relief for households, which will be welcome from households, no question about it, but just adds a little bit more upward pressure to the economy. And in the current environment, we're still not 100% sure that inflation is going to land at 2% with the rate path that we anticipate, so further rate cuts. It does to some extent imperil the way forward on rate cuts and depending on when it's done, depending on how it's done. But it is it is a concern.

SM: And of course, now we're getting a fall fiscal update from the federal government next week and heading into an election season, probably more spending on top of that.

JFP: Of course. I mean, that was fully expected, we've been talking about this for a long time, that as you get into the federal election cycle, and maybe some provincial election cycles, that you will have governments try to be more generous with taxpayers than they normally are through some rebates, as we've seen, or some other spending measures that are yet to be announced. So it's our expectation that we will be surprised on the more spending side as we go forward, rather on less spending side, just because that's pretty typical behaviour as you head into elections.

SM: Right. Okay. Before we let you go, what are the main couple of takeaways that Canadians should have from the latest decision?

JFP: The first takeaway is the obvious one, which is rates have come down a lot and that is going to help households tremendously. And we expect rates to come down a little bit further. So, a little bit more rate relief on the horizon. So a better environment for households to make financial decisions in. Then again, the flip side of that is we are getting towards the end of that rate cutting cycle, we don't expect that many more rate cuts, maybe one or two. We'll see how that works. So, households shouldn't expect that six or eight months from now, rates are dramatically lower than where they are now. So don't be overly hopeful on the rate cutting side. Just think that you maybe got a couple more rate cuts to go and plan accordingly on that. Otherwise, if your hope is that rates by the Bank of Canada come down to 2% or below, you might be disappointed and you might make the wrong decision for yourself.

SM: JF thank you, as always, for joining us. Really appreciate you taking the time.

JFP: Thanks for chatting, Steve.  

SM: I've been speaking with Jean-François Perrault. He is the Chief Economist at Scotiabank. And by the way, this is our last episode of the year, we’ll be back in early January. Hope you all have a good holiday.