We have now reached a moment of truth for at least two major central banks. With the Federal Reserve all but certain to keep rates steady at the June federal open market committee meeting, and most likely into late July as well, the European Central Bank (ECB) and the Bank of Canada (BoC) must now decide whether to essentially go it alone at rate decisions tomorrow.
There actually doesn’t seem to be all that much debate at the ECB. Even with a mild upside disappointment in the early read on Euro area May inflation— both headline and core Consumer Price Index (CPI) came in a tick high at 2.6 percent and 2.9 percent, respectively— officials have heavily signalled a rate cut is coming on Thursday. Following the earlier lead of first Switzerland, then Sweden, the ECB is widely expected to clip its refinance rate 25 basis points to 4.25 percent, nearly two years after first lifting it from zero.
The picture for the Bank of Canada is much less clear-cut. With its much tighter linkages to the U.S. economy, it’s a much bigger decision for Canada to carve out a quasi-independent policy path. But, unlike the U.S. experience so far in 2024, Canada has seen a run of better-than-expected inflation results, cutting all major measures of core inflation to below a 3 percent annual pace, and below a 2 percent trend in the past three months.
And the final piece of the Bank of Canada’s puzzle—Q1 real GDP—came in much lighter than expected at 1.7 percent growth, on the heels of a big downward revision to the prior quarter to just 0.1 percent (from 1.0 percent). Even with a rebound in April, the bigger picture is that GDP is up less than one percent in the past year, compared with almost 3 percent year-over-year U.S. growth over the same period.
Graphic credit: Janice Nelson
In other words, the U.S. economy has outpaced Canada’s by more than 2 percent in the past year, a very wide gap indeed. The U.S. core consumer price index is running at 3.6 percent year-over-year, almost a full point above the comparable measure in Canada. And, the U.S., unemployment rate has nudged up a half point in the past year to a still-low 3.9 percent, while Canada’s jobless rate has jumped a full point to 6.1 percent. Reinforcing that message, the job vacancy rate in Canada has fallen all the way back to pre-pandemic levels at 3.4 percent. Pulling all these threads together, there is a very good case for the Fed to remain patient, but there is an equally good case for the Bank of Canada to begin trimming rates, forthwith.
We have previously noted that one of the biggest obstacles to Bank of Canada rate cuts was a potentially weaker currency, which could then blow back onto inflation. Yet, the loonie has been a picture of calm and good behaviour as of late. Even as markets upped the odds of a BoC rate cut, the currency managed to firm slightly this week to 73.3 cents (or $1.364/US). This is not far from the 74 cent average level of the past 12 months. Moreover, it’s not like import prices are a big driver of domestic inflation these days; the import deflator was down 0.5 percent year-over-year in Q1, compared with a 3.4 percent year-over-year rise in domestic prices.
Another big concern for the Bank of Canada has been the stickiness of wages, and persistent inflation expectations. The latest consumer expectations survey shows that while short-term inflation is expected to remain high, it’s expected to cool to closer to three percent over the next five years. True, that’s a full point above the Bank’s target, but it’s actually below the expected rate back in pre-COVID days. On the wage front, fixed-weight average hourly earnings rose 4.1 percent year-over-year in March, up from 3.5 percent last year. But the looser job market should more meaningfully cool pressures in the year ahead.
Perhaps slightly helping the rate cut cause, were some signs this week that even the mighty U.S. economy is losing some of its zip, opening the door to potential U.S. rate relief later this year. First quarter GDP was revised down to a mild 1.3 percent pace, and just 1.7 percent for final sales. Consumer spending started Q2 on a soft footing, with real outlays dipping 0.1 percent in April. Home sales have stalled out amid seven percent mortgage rates, and the trade deficit is widening again. Meantime, the headline indicator of the week came in largely as expected, with the core PCE deflator rising a mild 0.2 percent in April (okay, 0.249 percent), holding the yearly pace steady at 2.8 percent (okay, 2.754 percent).
A light installation is projected onto the building of the European Central Bank during a rehearsal in Frankfurt, Germany, on Dec. 30, 2021. Inflation fed by high oil and gas prices hit record levels in Europe for the third month in a row, extending pain for consumers and sharpening questions about future moves by the European Central Bank. The 19 countries that use the euro currency saw consumer prices increase by an annual 5.1% in January, the European Union statistics agency Eurostat reported Wednesday, Feb. 2, 2022. (Michael Probst, File/AP Photo)
As a result of the downward revision to Q1 and the sluggish April result, we have clipped our full-year estimate of U.S. GDP growth two ticks to 2.2 percent. While not a huge change, suffice it to say that we have not cut our growth estimate in a very long time. It’s mostly been a one-way street higher for more than a year. That change in direction is potentially a very big deal, as it reinforces the message from the economic surprise index, which has been consistently on the weak side in recent months. The key takeaway is that the upside surprises in the U.S. economy for both growth and inflation seem to have drawn to a close, raising the chances of Fed rate cuts in the second half of 2024. We are circling the September and December meetings.
The slightly increased chances of Fed rate cuts in 2024 add one more arrow to the quiver of factors favouring a BoC rate reduction tomorrow. It also helps the cause that the ECB is highly likely to cut the next day, providing the Bank with some cover. While it may well be a watershed decision, we believe that the combination of sub-one percent growth, sub-three percent core inflation, and a plus-six percent jobless rate are all the reasons the Bank needs to pull the trigger.
This article was originally published at BMO.
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