A rate cut is in the cards. Here’s what might hold the Bank of Canada back

The economic stars appear to be aligning for the Bank of Canada to deliver an interest rate cut on Wednesday, but some economists warn the central bank might have other ideas when it comes to the right timing for the hotly anticipated first cut of the cycle.

The Bank of Canada has kept its policy rate – the benchmark rate for major Canadian loans like mortgages as well as borrowing costs for businesses and governments – on hold at 5.0 per cent since July 2023. Higher interest rates discourage spending and slow growth, which takes away some inflationary fuel out of the economy.

Governor Tiff Macklem said at the central bank’s last rate decision in April that an initial cut at the upcoming meeting in June would be “within the realm of possibilities.” That was dependent, he said, on whether inflation and other economic indicators continued to decline according to the Bank of Canada’s expectations.

Since that time, inflation has continued to ease. The April reading showed annual inflation had cooled to 2.7 per cent from 2.9 per cent in March, for instance, with the central bank’s preferred metrics of core inflation also showing signs of slowing. That comes despite persistent pressure in shelter inflation pushing up the headline number.

On Friday, Statistics Canada’s latest real gross domestic product report showed a steeper slowdown than most economists – and the Bank of Canada – were expecting.

“We’re looking at a situation where the economy has been struggling under the weight of high interest rates and inflation has become quite behaved,” says TD Bank director of economics James Orlando.

“(Monetary policymakers) absolutely have enough justification, economically, to cut interest rates. They’ve had that for quite a while.”

Following the GDP report, financial markets shifted their odds for an interest rate cut on June 5 to upwards of 80 per cent. Many economists also firmed up their expectations that cuts would begin this week, though some held to calls for an initial 25-basis-point drop in July.

Waiting to cut would be a 'policy error': economist

One piece of data that could stick out to the Bank of Canada’ governing council is a robust April jobs report, which showed that Canadian employers added 90,000 net new positions in the month.

Wage growth eased to 4.7 per cent from 5.1 per cent the month previous, but the Bank of Canada has signalled that the pace of pay hikes might not be consistent with getting inflation back to the two per cent target.

But Orlando says the trend is clear in the labour market, which has loosened significant over the course of the rate tightening cycle. Wage growth, while still high, is a lagging indicator as Canadians bid up their pay in an effort to catch up with rampant inflation, and he expects it to continue to cool amid the “stagnant” economy.

Cutting interest rates on Wednesday would mark a significant turning point in the Bank of Canada’s efforts to tackle inflation, which began in March 2022 and saw the policy rate rise 4.75 percentage points since then in rapid fashion.

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Many Canadians have renewed or are set to renew their mortgages amid the new higher interest rates, which will ratchet up their monthly payments and leave less room for spending elsewhere.

Some 44 per cent of Canadians are still citing money as their biggest stressor, up six percentage points from last year, according to the FP Canada 2024 Financial Stress Index released last month.

Tu Nguyen, economist at RSM Canada, says an interest rate cut on Wednesday is backed up by economic evidence and would come as a significant relief to consumers and businesses.

“We believe that if the Bank were to wait any longer, that would be a policy error,” she tells Global News. “All the signs set the stage for the start of the easing cycle to begin.”

Why the Bank of Canada might wait anyways

But Orlando is among those not convinced that the Bank of Canada will pull the trigger on Wednesday.

“Just because everyone’s talking about the potential for a rate cut this week, it still might not happen,” he says.

Despite the rush in financial markets to bet on a June rate cut last week, he believes these odds underestimate the strength in Canada’s economy.

Slow inventory accumulation was cited by StatCan as the biggest drag on Canada’s economy in the first quarter of the year. But without that drag, Orlando notes that real GDP would’ve been up by roughly three per cent on an annual basis in the first quarter of the year, driven by consumer spending on services like travel and dining out.

Ipsos polling conducted exclusively for Global News last month showed Canadians are continuing to find money for vacations this summer despite feeling the financial pinch.

This suggests a resiliency in the Canadian consumer despite higher interest rates, Orlando argues. The Bank of Canada might well be “spooked” by what happened in the United States earlier this year, he says, when a tick up in services spending reignited inflation that had, up to that point, been cooling.

With the economy not in a technical recession and consumers still spending, the Bank of Canada has an option to hold its rates for a little while longer before feeling any urgency to cut, Orlando says. Doing so could give the central bank confidence that its inflation progress to-date won’t be compromised, and avoid the chance it would have to return to tightening.

“It’s not like the economy is falling off a cliff,” Orlando says. “And that gives the Bank of Canada optionality for when it decides it wants to cut interest rates. It can cut interest rates this week, or it can wait till July or can wait even longer if it really wants to.”

Nguyen doesn’t think the Bank of Canada would be risking any of its progress on inflation if it were to cut on Wednesday. A policy rate of 4.75 per cent is still “very restrictive,” she says, and would not change the financial equation for many Canadians or businesses to prompt a new wave of spending.

Cutting interest rates now just sends the signal to Canadians that they can start to plan for a lower interest rate environment in the future, Nguyen says.

“Even though the rate still remains restrictive, it sends a signal to Canadian households, Canadian businesses that the start of the recovery can begin,” she says. “And so that there is hope at the end of the tunnel.”

Signals could be just as important as cuts

Signalling future moves to help Canadians plan ahead is an important function of the central bank. But while Nguyen believes the April rate decision and its clear markers for progress in the inflation fight opened the door to rate cuts in June, Orlando is looking for more.

The Bank of Canada has “historically been quite transparent” on signalling future moves before it actually enacts them, he argues, so as to avoid surprising Canadians or spurring volatility in financial markets.

He thinks it’s likely, then, that monetary policymakers will use the June meeting to “tee up” a July interest rate cut, when the central bank will also have a new monetary policy report with revised forecasts for inflation and economic growth.

This pronounced certainty, even without an actual interest rate cut, can also have a loosening effect on the economy just by setting expectations, Orlando says.

Forecasts for future interest rate cuts are priced into the Canadian bond market, including the benchmark five-year Government of Canada bond that helps set the rates for five-year fixed mortgages.

Falling rates can inform how much Canadians will pay on a new or renewed mortgage or a car loan, or that a business will get for their planned investments, allowing a soft start of sorts to the economic recovery, Orlando explains.

Whether the Bank of Canada cuts its benchmark interest rate on Wednesday, or it provides a clear signal of future cuts, Orlando says that will likely feed through to the housing market as sidelined homebuyers and sellers get a clearer picture of what they can afford.

Both Orlando and Nguyen say they don’t expect a single rate cut of a quarter percentage point will change the affordability outlook for many buyers wanting to break into the housing market.

But the demand that might have materialized in this year’s slower-than-normal spring housing market might be deferred to the summer, Orlando says, depending on how clear of a signal Canadians get that borrowing costs are set to fall in the months to come.

“I don’t think the quarter-percentage point is really a defining factor. I think the certainty around that interest rates are getting cut and that they will continue to get cut is really the signal that people need to decide on whether they want to jump in or not,” Orlando says. “So this summer might be a really big time period for the real estate market in Canada.”