Stephen Meurice: The Bank of Canada has announced another interest rate cut. Not as big as the last two, but a cut nonetheless.
Tiff Macklem [at press conference]: Today, we lowered the policy interest rate by 25 basis points. This is our sixth consecutive decrease and brings the policy rate to 3%.
SM: That’s Bank of Canada Governor Tiff Macklem at his latest news conference.
Tiff Macklem [at press conference]: We have three main messages this morning. First, inflation has been close to the 2% target since last summer. Monetary policy has worked to restore price stability. Second, lower interest rates are boosting household spending, and economic activity is picking up. But third, the potential for a trade conflict triggered by new US tariffs on Canadian exports is a major uncertainty.
SM: Here as always to break down the announcement is Scotiabank’s Chief Economist, Jean-François Perrault. He’ll tell Armina Ligaya how the Bank of Canada may have come to this decision, how things like potential tariffs and other economic and political uncertainties may weigh into future decisions and much more. I’m Stephen Meurice and this is Perspectives. Now, here’s Armina Ligaya.
Armina Ligaya: JF, welcome back to the show.
Jean-François Perrault: It’s lovely to be back with you.
AL: So, the sixth consecutive of cut for the Bank of Canada, but smaller than the previous two. What is the main headline or takeaway here?
JFP: Well, I think there's kind of two buckets of takeaways on this decision. One is looking at what the Bank of Canada is doing in relation to managing the previous inflation issue and where we are on that. And then the other bucket is how do they think about the risk of tariffs and how might they respond to that? So there's much more clarity on the first thing, which is, as you've indicated, they cut by 25 basis points to 3%. They've indicated as part of that that they're pretty comfortable now with the inflation outlook. So risks are balanced around the inflation outlook, in their words, the economy is responding well to lower interest rates, so the household spending is picking up nicely. You read that and you kind of come off with the impression that they're probably close to being done, maybe a three or maybe a little bit more of a rate cut. But they seemed reasonably comfortable with that side of things. Now, again, the second bucket, the uncertainty surrounding the tariffs that might be put on us as of perhaps February 1st, we'll see, those pose a significant amount of challenge to how the Bank of Canada will think about the outlook as it is the case with us and our clients and our customers – that muddies the waters quite a bit in terms of where the economy is going to go, what inflation is going to do and how the central bank will respond to that. But if you set that aside and focus on the decision of the day, which is the lower interest rates, it does look like the Bank of Canada is pretty comfortable with where rates are now and that if they move them going forward, it'll be on a case by case decision based on how the economy is responding to various things that are thrown at it.
AL: Definitely a lot of moving parts there. So, obviously it's always great to have you to discuss and break these things down, but this one in particular is quite complex and as you mentioned in a couple of buckets. So, what is your take? Was this the right call, given those various factors?
JFP: I mean, it’s debatable. So we thought they were going to cut and they cut. And that's largely because the market was basically giving them this pass. But when you look at how the economy has responded, the case for cutting was less clear cut. Inflation a little bit above 2, underlying measures of inflation in the 3 to 4% range last several months, the economy performed well in the fourth quarter. Job growth has been really strong in December. The rate sensitive parts of the economy have turned around. So, the case for cutting wasn't a slam dunk for us. In fact, I think we would have preferred them to stay on the sidelines for this decision. But the fact that they cut was in line with expectations. So, there's no surprise there.
AL: You said that the takeaways were in two buckets. But I am wondering, while the decision today hinged a lot on what has led up to this point, so obviously tackling inflation, all those other factors. But with this new factor of potential tariffs, how much, in your view, did that weigh on the decision, not the forecast necessarily, since they did leave that out of their forecast, but on this actual decision. Did that factor in in any way?
JFP: It's not clear. I mean, if you listen to the press conference and the governor was asked a version of that question a number of times, he indicated that it was important for the economy to be in as good a standing as possible to handle what it is that will come. So obviously, if rates are closer to neutral and 3% is consider neutral, then three and a quarter. If inflation's at 2%, if the economy is already responding to higher to lower interest rates, that is a good position from which to manage whatever is going to come our way. So, at the margin it might have impacted them a little bit to maybe cut a little bit more than perhaps the data would have suggested, at the very margin. But whatever will come is going to potentially dwarf any of those considerations depending on what happens and how we respond, how the Government in Canada responds.
AL: So, the Bank of Canada also released their monetary policy report, which gives us some indication of where they think the state of the Canadian economy is going. What did we learn about what they see ahead?
JFP: Well, a couple of things. So, again, they're comforted by the fact that the economy is responding well to interest rates. So, they have reasonably strong growth in household spending going forward. And that's in line with our view, in line with what we've been seeing for quite a few months. But it is comforting for them to see that as well. They expect growth of 1.8% this year. So just a little bit below 2. A significant acceleration relative to 2024. And they also revised upwards their forecast inflation a little bit. Not a lot, but a little bit. So on balance, you're looking at a situation where coming back to the incoming data, coming back to some of these concerns that residual concerns that we have on inflation side, the Bank of Canada’s signaling that while they're comforted about where inflation is, at the margin, the inflation outlook has deteriorated a little bit, absent any tariff related issues. This is just the data that is coming in and how their forecasts reflect those, because they were very clear that in the design of their forecast in this monetary policy report that they were not building in any assumptions with respect to tariffs or responses. Those are left to basically do some scenario analysis around eventual decisions, but those were not reflected in their main outlook.
AL: But they did in this case have a sort of special focus on just exploring specifically the impact of any potential tariffs, a more extreme scenario. What did we learn about their view about what a trade war scenario would look like and what would that mean for interest rates?
JFP: So I'm not sure we learned a whole lot. And in fact, because I don't think that they have a whole lot of confidence in their understanding as well. So you're right, there was a spec section in the monetary policy report this time around that laid out a hypothetical tariff scenario. 25% tariffs on everything coming in the United States and everybody responding in kind with some fiscal policy offsets to that. Now that scenario, which is illustrative only, but they did that to kind of give people a sense of how things might evolve if we find ourselves in that bad outcome. Saw very significant declines in economic activity. No surprise there, but a very significant increase in inflation as well. In fact, despite the decline in economic activity, you have an acceleration of inflation in the last three years. So, the question, of course, in that context is, well, what does the central bank do if you have lower growth but higher inflation? And there the answers are very, very unclear, as the governor made very clear in his responses to that during the press conference, which basically dominated the press conference. It depends on how scenarios differ from those very general assumptions, how governments respond, how the exchange rate responds, how firm behaviour adapts, how inflation expectations respond. All those things could mean that the central bank may need to raise interest rates or may need to cut them, depending on which is the primary driver of the macro economy as we go forward. And unfortunately, the governor is no better informed than almost any of us are in terms of understanding what President Trump may or may not do and, of course, how financial markets and how our government response to what is eventually done, if something is eventually done by the Americans against us. So just a huge amount of uncertainty around all that. Uncertainty about what might happen and uncertainty how policymakers are going to respond.
AL: So going back to your outlook for the Bank of Canada's decisions and, of course, with the caveat that there's a lot of moving parts, a lot of things that can change and quite rapidly. What is your outlook for the central bank's decisions for the rest of the year? I think some economists are expecting two cuts. You said maybe one. What is your thinking on this?
JFP: I mean, we're pretty comfortable right now with saying they're going to stay put at 3%. I mean, that was our expectation coming into this meeting that they would cut and then they would probably stop. Now, it's not a huge confidence call. They could cut a little bit more to 2.75% or so. But again, as we read the tea leaves, the rate sensitive parts of the economy are improving very significantly, as the governor agreed with. Inflation at the margin is picking up a little bit. So, revising upwards those inflation forecasts. That to us suggests that despite the uncertainty, despite some probable weakness on the business investment side, as with all the uncertainty, suggests the Bank of Canada's close to being done or might be done.
AL: Is there any risk at all that rates might go up again?
JFP: Yeah, it's not inconceivable. So if we find ourselves in a very aggressive tariff scenario where prices respond very significantly to higher tariffs, even though growth slows down, that that increase in inflation – and if it's persistent and perceived as persistent – could lead to higher interest rates from the Bank of Canada. Now, we don't think that's particularly likely, but it's not impossible. And the governor wouldn't say how likely it is that he would cut versus raising interest rates because of all these other considerations. But one of the key factors in figuring out how the Bank of Canada is going to respond to that, in addition to the minutia of whatever policies are implemented, is how inflation expectations evolve in relation to an expectation that tariffs will be put in place. Now, inflation expectations are really important for the Bank of Canada. They are really important for the economy, because it gives a sense of where people think inflation is going to go. And of course, the more people think there will be inflation, the likely it is that inflation will go in that direction. The more likely it is that people will ask for higher wage increases, that feeds inflation. And the experience we have here is that of the pandemic, where we went through a very nasty economic shock. There's no question about that. Very significant decline in economic activity for a period of time. It was a supply shock combined with a demand shock. So a bit of the stuff that might happen kind of in the tariff context in that you've got interruption of supply because, well in the pandemic case, because supply chains were closed. In the tariff case, because you're throwing tariffs at stuff. And we saw over a reasonably short time horizon that once inflation started to go up, people's expectations of what might happen to inflation change very quickly. And that became a problem for the Bank of Canada, because if you're telling folks inflation is going to be temporary, transitory, which was the message that central banks were sending out during the early days of the pandemic, and that ends up not being the case. Then you get a pretty vicious response in how people think about inflation going forward. So, I think they've internalized that lesson. So going into this environment where again, there may or may not be tariffs going forward, but if those tariffs are put in place, it could very well be that all the talk of tariffs over the last year or the experience of the pandemic, the loss of credibility to some extent of the central bank means that inflation expectations pick up a little bit more rapidly than otherwise would be the case. And that kind of handcuffs the Bank of Canada in terms of its policy response. And maybe if that happens, maybe they need to raise interest rates.
AL: Wow, so then what does all this mean for the average Canadians? We can start with the housing market, obviously those with mortgages, the many who are renewing their mortgages this year or looking to buy a home, what is your guidance for them as they're looking at all this uncertainty as to where interest rates or even the ripple effects on the housing market could have an impact?
JFP: Clearly the risks going forward are of greater rather than lower inflation. The risks going forward at the same time are weaker rather than stronger growth because of this this tariff issue. Our sense is at present that even if we assume a little bit of tariffs coming into place in 2025 or later in the year or in 2026, that that probably keeps the Bank of Canada on the sidelines. If it's a moderate increase in tariffs. So, from a borrowing perspective, perhaps no need no need to worry too much about rising borrowing costs, certainly in the short end. So those folks who are thinking about variable rate mortgages and whatnot are probably safe. The further out you go in the curve, say five-year space, then things get a little bit trickier because you have inflation risk that starts to get priced into markets if these things happen. So maybe you get an increase in longer term borrowing costs. But in the short end, I think the path is pretty clear, either stable or lower from where they are now. Because to your point, I mean, we are of the view of the Bank of Canada is more or less done. But other banks have got significantly lower rates than where we are. But from a housing market perspective, it's not just the interest rate issue. Like we know that that's had an impact, of course. But there is also the supply demand imbalances, which is quite meaningful. We know there's a lot of pent-up demand. We know people are waiting to get into the market. We know the regulatory changes that came into effect late last year, they're going to boost activity in the first part of the year at least. So we're still pretty confident the housing market is going to do well as we get into the spring market and rates at the margin might mean that's a little bit less strong of a recovery here. But the dynamics are still, I think, pretty favourable for that.
AL: And what about for businesses and consumers? What are the considerations they should take into account looking ahead with all of these situations that are fast changing.
JFP: You know, they're in the same boat as everybody else. You know, the reality is that forecasting is exceedingly challenging these days just because it's state dependent. Are they going to be tariffs or not? Are we going to have clarity on whether there are tariffs or not? So one of the immediate consequences of this threat of tariffs is uncertainty. So, we've seen measures of uncertainty rise ahead of whatever might happen on the tariff side. There could be nothing. There could be something. But just the fact that you're worried about something creates elevated levels of uncertainty. So we know businesses are being a little more cautious. It makes sense. We know businesses are thinking about planning a little bit differently. So doing these war games, you know, ‘How do we deal with this situation, that situation or this situation?’ There's a preparation involved. And we know that some businesses are importing more stuff now to get ahead of tariffs, if there are any or sending more stuff to the U.S. in case tariffs are put in place there just so you've got a bit of a buffer to play with. In addition to some businesses thinking about, and some households I suppose, thinking about protecting themselves against various scenarios through financial derivatives. So, getting a currency hedge, getting interest rate hedge just to minimize, to the extent that you can, some of the variability in what might happen if you effectively purchase insurance against some financial outcomes. So, there’s a range of things that are being considered, but of course, uncertainty is never a good thing. Uncertainty means that people behave differently than otherwise would be the case. It means that, generally speaking, that folks are a little more cautious than otherwise would be the case, and that might be the right thing to do if in fact, tariffs are put in place. It could be the wrong thing to do if you're if you're cautious to the point where you're missing out on opportunities, because there are still plenty of opportunities as indicated. We know the rate sensitive parts of the economy in Canada are doing pretty well right now and probably will continue for a while despite some of the uncertainty that we've seen.
AL: So overall, what are the main takeaways in your view, for Canadians from this decision?
JFP: Well, the first is, obviously, rates have come down, so borrowing costs are likely to come down a little bit a result of that. And we are, I think, very close to the end of that rate cutting cycle. So our sense is planning around that is the right thing to do. The second is, that even though we have this view that we are towards the end or maybe at the end of the rate cutting cycle, that there is just massive amounts of uncertainty with respect to where things go from here. And that uncertainty will be clarified to some extent as we get indications of what happens in the U.S. and how the Americans think about us. But that is the reality of the day.
AL: Thank you very much, JF, for returning to the podcast to break down this particular decision at such a complex time.
JFP: Lovely to be with you, Armina.
AL: I've been speaking with Jean-François Perrault. He's the Chief Economist at Scotiabank.
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