Canada Monetary Policy Monetary

Since the Bank of Canada decided to keep rates on hold at 3% at the July 15 Fixed Announcement Date, there has been a rather significant shift not only in the economic data, but also in how the market is pricing in future rate moves by the Bank. The accompanying statement to the July 15 meeting indicated a neutral bias, saying that "the current level of the target for the overnight rate remains appropriate" and risks were balanced. Since then, however, a raft of soft economic data has prompted the market to price in a rate cut.

The economy is unambiguously weak and the slowing economic activity has had some impact on inflation. But in our view, this does not suggests a slam dunk case for a rate cut. In fact, it seems as though the Bank is comfortable with the overnight rate at 3%. Recent comments by Deputy Governor Longworth reinforced a neutral bias when he spoke on August 26. There remains some uncertainly with respect to where inflation will go in the near term and there remain subtle points of strength in the economy and inflation. There is some degree of credibility risk associated with making a move when the market is mostly pricing no change in the overnight rate. As such, by keeping rates on hold on September 3, the Bank gives itself a bit of breathing room to see how conditions unfold and avoid the market's ire. Thus, we maintain the view that the Bank of Canada will remain on the sidelines on September 3, leaving the overnight rate at 3%.

A slowing Canadian economy means the output gap will move further into excess supply. In turn, that will take some of the pressure off inflation, and indeed, there has already been some evidence of that.

The recent inflation data has certainly come as a welcome surprise. In July, core CPI was a touch soft, with a 0.1% SA M/M gain, leaving the annual rate at 1.5%. Headline CPI remained somewhat elevated with a 0.35% SA M/M gain. On an annual basis, headline CPI rose to 3.4%, which is the highest of the cycle, as food and energy prices continue to figure in to the calculation in a big way.

The breakdown in the inflation data suggests that the slowdown in the Canadian economy is starting to have some impact on prices, and will continue to do so as the economy moderates further. Prices for goods were up only 0.4% M/M in July, after averaging 1.05% M/M in the prior quarter. Moreover, services inflation seems to be moderating as well, with only a 0.25% M/M gain in service prices in July. But both are still elevated when compared to a year ago. Goods inflation rose to 3.2% Y/Y in July, and services remained relatively elevated at 3.5% Y/Y. But continued softening in economic activity should put a lid on goods prices going forward. In turn, that should prevent any significant gains in core inflation.

On the labour market front, any wage pressures that were previously present, have now abated, as the labour market continues to lose steam. Canada has lost 60.2K jobs in June and July and that has taken much of the froth off wage pressures. In this cycle, average hourly wages peaked at 4.9% Y/Y in January, and by July, they were 3.8% Y/Y. As the economy cools further, so too will job growth and workers will ultimately have less bargaining power. In turn, that will further limit wage pressures.

Uncertainty Lingers

But while the outlook for inflation going forward looks tame, there is still some uncertainty.

First, the alternative inflation indicators that the Bank of Canada cares about do not look as tame as the reported inflation data and are trending around the 2-3% range. Second, the Bank has noted some concern about pass through from prior commodity price increases through to headline inflation. Third, energy prices have fallen quite dramatically through August, which suggests that July might be the last time that they factor in to headline inflation so heavily. In July, it was not gasoline prices that drove the energy component of headline inflation, but rather natural gas. The former only rose 1.2% M/M, while the latter rose a massive 8.8% M/M. Gasoline prices have dropped about 5% since July, as demand destruction heats up, which suggests some moderation in the energy price component in upcoming months. Still, energy prices are not governed solely by logic alone, and energy prices could very well begin to rise again, especially if the hurricane season yields some bad storms. This is a risk the Bank must watch for. Fourth, the Canadian dollar has lost just over 4% since July 15, and with the bull market in commodities now largely in the rear view mirror, we expect the Canadian dollar to ease further against the U.S. dollar. This creates an uncertain interplay between the two drivers, and likely leaves the Bank of Canada loathe to act until there is a clear direction in all inflation trends.

Growth Story Winds Down

Second quarter GDP was not as bad as feared, but certainly lower than expected and it missed the Bank's forecast by a sizable margin. GDP posted a 0.3% Q/Q, annualized gain, and first quarter GDP figures were revised down significantly to -0.8% Q/Q, annualized (compared to a decline of 0.3%). It is clear growth in Canada has embarked on a softening trend. Fortunately, it has not entered a technical recession, but softness is still prevalent.