Bank of Canada policymakers at odds over when they can justify interest rate cut

Deliberations shed light on one potential risk to the inflation outlook: the housing market

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Bank of Canada policymakers are divided on when there will be enough evidence that the right conditions are in place to cut interest rates, though they agree it should be sometime this year, according to a summary of deliberations that led to a decision to hold the key overnight rate at five per cent on March 6.

“Members agreed that if the economy evolves in line with the bank’s projection, the conditions for rate cuts should materialize over the course of this year,” according to the summary released March 20. “However, there was some diversity of views among governing council members about when there would likely be enough evidence that these conditions were in place, and how to weight the risks to the outlook.”

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The deliberations shed light on one potential risk to the inflation outlook: the housing market.

“While house prices continued to fall in January, recent strength in resales could translate into a pickup in house prices and stoke shelter price inflation,” a potential outcome they discussed, according to the summary.

However, in what is sure to be a disappointment to some market watchers predicting an early rate cut, Bank of Canada governor Tiff Macklem and the five other governing council members concluded they cannot “look through” the impact of past interest rate increases on mortgage costs, which is driving shelter price inflation.

“Members agreed that if mortgage interest costs were the only component holding up inflation, there could be some capacity to look through them, so as not to unduly restrain economic activity to get headline inflation back to (the central bank’s target of) two per cent,” the summary said. “However, this was not the current situation. Most components of shelter inflation, such as rent and expenses related to homeownership (including insurance, taxes and repairs), were still rising significantly in January.”

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Governing council members also noted that Canada’s mortgage renewal cycle means higher mortgage interest costs will have a “persistent, but not permanent” effect on CPI (consumer price index) inflation.

The central bankers acknowledged that shelter price inflation, which includes mortgage interest costs, rent and components related to home ownership, remained high at 6.2 per cent in January, and continued to be the biggest contributor to total CPI inflation. They also agreed that recent housing market indicators suggest this is likely to persist, which would mean that high shelter costs will continue to be an important contributor to CPI inflation.

Still, they concluded that “recent data had made it clear that inflationary pressures were still broad-based, and underlying inflation had yet to show sustained downward momentum.”

The policymakers also agreed they would need to see further and sustained easing of underlying inflation before cutting rates. Their focus will be on core inflation as well as several key indicators, including corporate pricing behaviour, inflation expectations, wage growth relative to productivity and the balance of supply and demand in the economy.

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The data they were working with in March indicated slow progress was being made in getting inflation down to the target of two per cent. The share of components in the CPI basket growing at more than three per cent continued to decline, but was still close to 45 per cent and remained significantly above the historical average.

The central bank’s preferred measures of core inflation that strip out volatile measures were both lower, at 3.4 per cent for CPI-trim and 3.3 per cent for CPI-median. However, both were still above three per cent when measured across 12-, six- and three-month periods.

“Governing council members saw nothing in the data that would change their view that CPI inflation will remain around three per cent in the coming months,” according to the summary of deliberations.

Since the March 6 rate-setting announcement, when the key overnight interest rate was held at five per cent for the fifth consecutive time, data shows inflation has eased while home prices have notched up slightly.

Headline CPI inflation surprised by falling to 2.8 per cent in February, with slowing food inflation among the reasons. The Bank of Canada’s preferred measure of “core” inflation, meanwhile, moved lower in February to 3.2 per cent year over year, compared to 3.4 per cent in January.

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Economists at Toronto-Dominion Bank said it was the first time since 2021 that grocery inflation was below headline inflation. Year-over-year grocery prices increased by just 2.4 per cent in February compared to a 3.4 per cent rise in January.

However, economic indicators continue to be uneven, with shelter inflation still moving higher. Rent inflation moved up to 8.2 per cent year over year, while the overall cost of owned accommodation was up 6.7 per cent, according to the TD report.

Housing prices in Canada’s 11 largest census metropolitan areas rose by 0.2 per cent in February on a seasonally adjusted basis, the first increase after four consecutive monthly decreases, according to the Teranet-National Bank Composite House Price Index, which was released March 19.

TD economists are forecasting the overnight interest rate will remain unchanged until July.

“We expect that inflation will have cooled enough by July for them to loosen up with a first interest rate cut,” they said in a note.

Andrew DiCapua, senior economist at the Canadian Chamber of Commerce’s business data lab, is also expecting the Bank of Canada to continue holding rates through June, while taking the time to digest two more inflation updates, updated surveys on expectations and a federal budget.

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But some market watchers are predicting a June rate cut.

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Dominique Lapointe, director of macro strategy at Manulife Investment Management Ltd., said there appears to be a growing emphasis on CPI measures that exclude mortgage interest costs, the largest contributor to inflation, reinforcing a dovish tilt at the Bank of Canada as inflation cools.

“Combined (with) nearly zero economic growth since the second half of 2023, we continue to anticipate that the BoC will set the stage for a June cut at its April 10 monetary policy report,” he said.

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