Even amid signs of slowing growth, the Bank of Canada is reiterating its commitment to fight inflation. Andrew Kelvin, Head of Canadian and Global Rates Strategy at TD Securities, says markets should interpret that as a signal from the central bank that a rate cut is unlikely any time soon.
Transcript
Greg Bonnell: Well, the Bank of Canada has held its key rate steady at 5%. But they’re also warning that they’re still concerned about underlying inflation and that, if they need to, they would hike further to tame inflation. Joining us now to discuss, Andrew Kelvin, Head of Canadian and Global Rates with TD Securities. Andrew, great to have you back on the program.
Andrew Kelvin: Thank you for having me.
Greg Bonnell: So we’ve got a whole day on our hand, but I guess what they would call the hawkish whole. Where we’re going to warn you, if things don’t go the way we want, we will raise rates again. What do we actually think we’re going to get from the Bank going forward?
Andrew Kelvin: So I’ll say up front, we do think the Bank of Canada is done. We think that 5% will be the peak rate this cycle. And we expect we’ll stay here for several quarters now. The thing that Bank of Canada wanted to avoid here is sending a signal to markets that they are going to quickly turn around and cut rates, because that is not their thought process currently.
The hawkish hold is designed to achieve a few goals. First off, they want to make sure inflation expectations remain well anchored. So they want to reiterate that they’re committed to bringing inflation back to 2%. Inflation, of course, is not currently at 2%. It’s running above three. So it follows that if their target’s two and inflation is above three, they can’t be happy with the state of the world as it is.
So they talk about how there are still lagged impacts of monetary policy, and how we’re still – we are now seeing signs of excess demand easing, of growth slowing. So there are signs that monetary policy is working. They expect it to continue to work further to keep growth on the slow side to bring inflation lower. And that’s why they believe they can stay on hold here.
But, if it turns out that these lagged impacts of rate hikes, if it turns out that the tightening already in place isn’t enough to bring inflation back to 2%, their mandate requires them to attempt to do more. And that’s just the message they’re trying to send here.
I don’t think it should be a surprise. It would always be hugely premature for the Bank to declare a victory with inflation running above 3% across a variety of metrics. But I think in terms of acknowledging that the growth has been a little bit weaker in the second quarter, that does show that they’re not gung ho on lifting rates, damn the torpedoes sort of thing.
Greg Bonnell: Well, when they talk about inflation coming down I don’t think the Bank of Canada or any central bank said it would be a straight line to get it back to two. And it will be a bumpy ride. And we saw it in the summer. We were sub-three, then we got back above it.
They did warn today that while the price of gasoline and the price of benchmark crude haven’t been on the rise lately, that we might even see inflation move a little higher from here before it goes down. They seem to be acknowledging that. So I don’t imagine that would knock them off their course. They’d say, well, we are expecting this.
Andrew Kelvin: If it’s just inflation moving a little bit higher because of higher gasoline prices, absolutely, you’re right. That won’t knock them off their course. That’s not to say we’re out of the woods here. Because if inflation moves higher by more than perhaps is expected, we will get a new round of forecasts from Bank of Canada in October as well.
But if you combine it with some of the other things they are looking at – wage growth, corporate pricing power, these sorts of things, excess demand – if you have a combination of an uptick in inflation, a broad uptick in inflation, so not just gasoline prices but core inflation broadly defined, and you combine that with either stronger GDP, or wage growth increasing, or the unemployment rate starting to fall again, a combination of those things could bring Bank of Canada hikes back into play in the future.
Now, as I said earlier, that is not our base case. But I think the Bank of Canada wants to make sure everyone is aware that they are not saying that 5% is the top. They’re saying, they think they’ve done enough. But the data needs to confirm that.
Greg Bonnell: What about that persistent underlying inflation? They talked about, well, headline is one thing, but looking at things – you mentioned wages. They did mention, they were saying, however, wage growth remaining around 4% to 5%. How sticky is that component of inflation?
Andrew Kelvin: I mean, we’re going to find out, I suppose. We are seeing wage settlements come through incorporating wage growth in that area. Productivity growth in Canada is not high enough to support 4% to 5% wage growth without it being inflationary beyond the 2% target.
Ultimately, the bet has to be that, as growth slows, the unemployment rate rises, particularly with a very strong population growth. We do enjoy strong labor force growth in this country, which means if you slow labor employment growth, not necessarily job losses, but just slower increase in jobs, you can start to increase the unemployment rate without actually sending the economy into recession.
And in that sort of world where you have a little bit less of a shortage of labor in some industries, the hope and bet would be that wage growth then slows. That’s what the Bank of Canada is looking to achieve here. They said in the statement that the slow growth that we’re seeing is needed to bring the economy back into balance. And, ultimately, that’s what they’re trying to achieve here, balance in the economy.
Greg Bonnell: When we think about the Bank’s trendsetting, and, obviously, that reverberates, that’s why it’s trendsetting throughout the bond markets and the economy. But what have the bond markets themselves been trying to tell us this summer? Because we have seen those yields keep pushing higher and pushing higher.
And particularly in the States today, I mean, what is the bond market saying? What are the central banks saying? And they don’t always sing the same tune. Sometimes they fall out of step with each other.
Andrew Kelvin: And it’s always particularly tricky as we head into the start of September, and I say that for two reasons. First, in Canada at least, you tend not to hear a lot of Bank of Canada communication the month of August.
So whereas the Bank of Canada does a pretty good job updating markets in between meetings, how they’re incorporating data surprises, we don’t get that ahead of the September meeting. We are left in the dark, as it were, as to how the Bank of Canada would interpret an upside surprise on the last CPI print.
Now, with the GDP numbers we had for Q2 that were quite weak, I think that eliminated a lot of the ambiguity. But that is one thing that is a little bit tricky about the month of September. You have a little bit less guidance from central bank officials.
Additionally, summer markets are just notoriously volatile. You get larger moves to data points than you would normally expect in the spring or fall. And sometimes markets just do strange things for reasons that market participants have a hard time explaining in the month of August.
So I think you can look at some of those big increases in yields we’ve seen over the last month, six weeks, as being exacerbated by these thinner trading conditions.
Having said that, I think the market is looking at the situation in the US, and they’re perhaps a little bit less certain than they had been in the past that the Fed is done here. And that is helping to push yields higher.
And, at the same time, we talked about the Bank of Canada mentioning that persistence of underlying inflationary pressures. I do think there is concern in some corners that with the persistence in underlying inflationary pressures, rates will be at higher levels over the medium term than perhaps people anticipated.
Because I think, earlier in the cycle, some people were perhaps thinking, sure, we’d get a pop higher in interest rates, but it would quickly reverse. And now markets are changing their expectations and changing their bets as to how quickly we’ll return back to – I don’t want to say the rates that we had before the pandemic, because those were strangely low rates, in my view – but how quickly we will return to normal or neutral rates. People are starting to revise those expectations.
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