From ‘gradual’ to a cut every meeting: Why are interest rate bets changing?

The latest inflation data from July sealed bets from economists that the Bank of Canada is set for its third interest rate cut in a row come September, with growing beliefs that there could be even more relief on the horizon.

Statistics Canada said Tuesday that annual inflation slowed to 2.5 per cent last month, the lowest levels seen since March 2021 and another step towards the central bank’s two per cent target.

The Bank of Canada uses its policy rate to broadly set the cost of borrowing across the country, raising the rate to cool the economy and tame inflation or lowering it to spur growth as needed.

Money markets and many economists are now expecting rate cuts of 25 basis points at each of the central bank’s remaining monetary policy decisions in 2024, a call which, if it comes to fruition, would bring the benchmark policy rate from 4.5 per cent to below four per cent by the end of the year.

Forecasts for how quickly the Bank of Canada will unwind its policy rate after the most rapid tightening cycle in its history have accelerated in recent weeks.

Recall that in June, when the central bank delivered its first rate cut in more than four years, governor Tiff Macklem told Canadians to expect a “gradual” pace of easing, that interest rates will not fall as quickly as they went up.

Back then, some forecasts called for an interest rate cut at every other meeting for the remainder of 2024, with the central bank hitting pause to gauge the impact of declining borrowing rates on the economy and Canadian households.

The Bank of Canada has maintained that it’s still taking a meeting-by-meeting approach to interest rates, scrutinizing the available data to say whether it’s clear to cut without reigniting inflation.

“The expected direction of our policy rate is lower, but we’re not on a predetermined path,” Macklem said after the central bank’s latest meeting in July.

Bank of Canada's shifting concerns

But TD Bank director of economics James Orlando argues the backdrop surrounding the rate path has meaningfully changed since June.

At that time, the Bank of Canada was cautiously kicking off the rate-cut cycle, worried that if it took its foot off the brake too early, inflation relief could stall and might not return all the way to two per cent.

Fears of inflation accelerating were particularly acute in the United States, Orlando notes, while economies on both sides of the border were showing little need for relief from the restrictive interest rate environment.

“Now, both of those factors have started to change,” Orlando says.

The latest communications from the Bank of Canada show growing fears that inflation drops too far below two per cent — also a problem for a central bank trying to achieve price stability.

Inflation is looking increasingly “well behaved” in both Canada and the United States, Orlando explains, with expectations that the U.S. Federal Reserve could begin its own rate-cut cycle in September.

A downbeat jobs report in the U.S. earlier this month also spurred fears in global markets that the Fed had waited too long to cut borrowing costs and that a recession could be in store.

That comes as the Canadian labour market is also showing cracks.

The unemployment rate rose to 6.4 per cent this summer as the economy shed jobs over the past two months, marking a change from previous labour market reports that largely showed employers were still hiring even as the jobless rate rose.

The Bank of Canada’s governing council expressed concern about the labour market deteriorating further in the deliberations behind its latest rate cut. If those signs of “slack” in the jobs market persisted, it could delay the rebound in growth and consumption, the minutes read.

So to sum up: the Bank of Canada is now less concerned that inflation won’t hit two per cent and more worried that the economy could take a bigger hit than first hoped.

“And so you have this massive runway for how much rates should probably be cut,” Orlando says.

How fast could rate cuts come?
TD Bank estimates the Bank of Canada has a lot of bandwidth for how much interest rates can fall without risking inflation progress. Orlando says he expects the central bank will keep cuts coming at “pretty much every meeting” until hitting two or 2.5 per cent by the end of next year.

Experts who spoke to Global News don’t expect the Bank of Canada to take any oversized steps on the easing path, sticking to 25-basis-point interest rate cuts instead.

Orlando says the cracks in the Canadian economy are not deep enough to warrant cuts any steeper than a quarter-percentage point.

Tu Nguyen, economist at RSM Canada, says the central bank is not quite ready to declare victory over inflation yet — something that will hold it back from cuts of 50 basis points or more.

Wage growth remains sticky, she says, and a rush into rate cuts could spur new inflationary fuels like a boom in the housing market triggered by cheaper mortgages.

Nguyen says she expects the Bank of Canada will lower its policy rate to four per cent by the end of 2024, with “a series of rate cuts in 2025 as well.”