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Bank of Canada continues to talk tough despite markets’ rate-cut expectations

Like a stern parent, the Bank of Canada once again reminded markets that it is prepared to raise interest rates further if necessary to bring down inflation.

And like rebellious children, the markets aren’t buying it, continuing to price in substantial odds of rate cuts starting as early as the second quarter.

As expected, the Bank of Canada today held its benchmark rate at 5%, where it’s been since July.

In its statement, the Bank said that while high interest rates have restrained consumer spending and “stalled” economic growth, it is “still concerned about risks to the outlook for inflation and remains prepared to raise the policy rate further if needed.”

In particular, the Bank will be watching for a continued easing of core inflation, which has hovered between 3.5% and 4% in recent months.

Markets have moved on from rate hikes

Despite its threats of further hikes, markets remain more focused on the timing of the Bank’s pivots to rate cuts.

As noted above, markets believe an economic slowdown and rising delinquencies will outweigh any lingering concerns about elevated inflation, as has been seen by the near-full percentage-point drop in the Government of Canada bond yield since it peaked in early October.

“The Bank again gamely said that it is ‘prepared to raise the policy rate further,’ even if no one is looking for further hikes, and the conversation has completely moved on to when cuts will commence,” said BMO Chief Economist Douglas Porter.

“Maintaining the hiking bias is likely driven entirely by a desire to continue dampening Main Street inflation expectations and keeping a lid on housing speculators, even as markets are pricing in more than 100 bps of cuts next year,” he added.

Bond markets currently see a roughly 33% chance of a half-point (50-basis-point) cut by March. By September, the markets believe there is a 19% chance of the Bank of Canada cutting rates by 125 bps (1.25 percentage points).

Among the big banks, most see the overnight target rate falling back down from 5% to 4% by year-end 2024. However, forecasts from CIBC and TD see it falling even further, to 3.50%.

Scotiabank economist Derek Holt also recently argued that the Bank will need to keep the market’s aggressive rate-cut pricing in check. Otherwise, “they are at risk of repeating what happened earlier this past spring all over again,” when its two-meeting rate pause prematurely triggered expectations that the rate-hike cycle was over, leading to a short-lived run-up in home sales and prices.

If bond yields continued to fall below 3% over the winter months, Holt said it could “unleash greater inflationary pressures through another powerful housing boom with spillover effects on related consumption.

Inflation concerns could still keep the BoC on hold for longer

Not everyone sees the Bank of Canada pivoting to rate cuts so quickly. RBC, for example, sees the first rate cuts not being delivered until the second half of 2024.

“Currently softer trends in consumer spending and labour market data are still consistent with a ‘mild’ economic downturn, and are expected to be extended into early 2024 alongside more easing in inflation pressures,” noted RBC’s Claire Fan. “Still, the BoC will be cautioning against pivoting to rate cuts too quickly.”

Similarly, Tony Stillo of Oxford Economics says, “we anticipate the Bank will hold interest rates until mid-2024 when evidence mounts that inflation is convincingly heading toward the 2% target.”

Featured image by DAVE CHAN/AFP via Getty Images