A Hitchhiker’s Guide to the Bank of Canada

Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Avery Shenfeld: Welcome everyone to this episode of CIBC’s Eyes on the Economy. I’m Avi Schoenfeld, Chief Economist at CIBC, and it’s my pleasure to be joined by my colleague Ali Jaffrey, who’s an Executive Director in our group and has come out with a new report that gives a guideline to how to watch the Bank of Canada like an expert and how to predict what it might do next. So we’re going to take you through some of what’s unique about the Bank of Canada versus the Fed. But I think one of the things, that is a big difference is the degree to which the central bank actually tries to guide the market as to what its next move is.

Ali Jaffery: Yeah, so that’s right, every the core difference between the two institutions is, you know, is the Bank of Canada focuses on the data and lets the data speak about their near term moves, whereas the Fed likes to choreograph their next move in something that we call near term forward guidance. you know, there’s good reasons for the bank doing what it does. know, Canadian data is more volatile, subject to large revision and short order. And Canada is also a small open economy and a commodity exporter. So has to put a lot of weight and attention on data from the United States and globally. And their words also don’t have as much power as the Fed’s, which is obviously the largest economy in dollar terms in the world. And Fed obviously has a huge outsized impact on financial markets. So there’s spillovers from the Fed into Canada’s financial markets. So it makes sense that the Bank of Canada has a more wait and see attitude than the Fed.

Avery Shenfeld: And while they’re waiting and seeing, of course, they’re watching the incoming data. And as you point out, in a small open economy, there can be surprises. And the Bank of Canada does seem, as you point out in your article, to pay some emphasis on this concept of shock minus control, what they were thinking was going to happen and what they’re actually seeing on the ground. So where have the surprises been in this easing cycle?

Ali Jaffery: So that’s right. There’s been a lot of surprises on the bank’s inflation forecast for the past three MPRs this year in 2024. We’ve seen consistent downside surprises on inflation that they’ve missed on their inflation forecast on the downside by an average of about point two percentage points on headline inflation and year over year terms. And you know, that’s that’s not a massive error, but that’s not also small. So we looked at the history of the bank’s inflation errors. And from the pre-pandemic period, they have fairly good forecasting record around zero, although inflation is more tame on that period. But we don’t have many instances of the bank missing three times in a row. In fact, the only time since 2012 that’s happened was in 2022 when it’s a lot of volatility on inflation. So the bank conducts its monetary policy by looking at a range of things. And one of those things is this in a modal projection or the most likely outcome, is how their forecasting framework is framed. So when you have inflation consistently come below that, think what it tells them is that there’s an urgency to move more quickly in terms of providing rate relief to Canadians and move the policy setting to a more neutral territory at least.

Avery Shenfeld: And that certainly was a factor then for the moving by 50 basis points rather than a quarter point that cumulative downside surprises on inflation. You do also point out that of course, like every other central bank, they watch measures of economic activity as well. But there is a difference between how they would express that in Canada versus the US in terms of whether they talk a lot about the labor market or GDP. Maybe you could give our clients some insights on that difference.

Ali Jaffery: Yeah, absolutely. So in the US, obviously, it’s pretty clear that the Fed puts the most weight in terms of activities on the labor market. They have a dual mandate, which explicitly has them trying to achieve a maximum sustainable level of employment. In Canada, certainly the Bank of Canada cares a lot about the labor market, and they added a maximum sustainable employment goal in the last inflation target renewal. But still, it’s pretty clear from the bank’s communication, from its models, that They put a lot of weight also on GDP, slightly more than they do the labor market. The output gap is typically framed in GDP terms. That’s what’s published on the website that plugs into their models. And there’s no real-time forecast of the labor market to judge the tightness or the amount of slack in the labor market. that’s one of the other big differences of BOC of Fed watching. Fed watching, you can really focus in zero on the labor market. The BOC, you probably have to pay a little bit more attention to GDP than you do the labor market. and do the math to see where the output gap is.

Avery Shenfeld: Certainly, that’s been consistent with what we saw with Powell saying he didn’t want to see the labor market weaken any further, but the Bank of Canada constantly talking about the economy being in excess supply, so using that output gap concept rather than any specific measure of unemployment. The bank also talks a lot about the balance of risks in its assessment. And you did some interesting analysis of the text of how that’s evolved since the start of the year. And where are we now on the bank’s judgment on those risks to inflation versus where we were earlier in the year when they weren’t yet easing?

Ali Jaffery: Yeah, this is another important area that I think doesn’t get a lot of attention. you know, the bank puts forward a projection, which they say is their most likely, you know, supposed to reflect the most likely outcome. But obviously, you know, that’s based on things that they know at the time, and they don’t speculate a lot about things like political outcomes, fiscal policy. And so they have to think about the risks to that outlook because they don’t have information on some of these other elements. And they try to develop an outlook that is Balanced with respect to these risks that there’s sufficient upside risk and downside risk so that they can believe in their projection So these are forces that are outside of their model or outside of their surveys and right now the bank has the bounce of risk is what they call reasonably balanced and you know, they have a set of upside risks and downside risk, but When we when we look through the minutes over the past year, there’s a using our in-house AI tool, which is ultimately based on chat GPT we asked this tool to identify how much of the text in the last two sections of the minutes that really talk about sort of the meat of the discussion is devoted to discussions of upside risk and downside risk on inflation. And we see some interesting trends where the share of text devoted to downside risk has been rising quite significantly and it peaked in September, which presaged the October 50 basis point cut and the discussion ofupside risk has fallen, know, secularly throughout the year and reached its lowest point in October. you know, although the bank may feel on the whole that the risks are balanced, it seems that the minutes suggest they’re probably talking a lot more about the downside risk than the upside risk. And that might suggest that overall, in time, this balance of risk could shift a little bit more to the downside. And, you know, given that what we’ve seen since the NPR,with changes to immigration policy and obviously the election of Trump in United States, the balance is probably moving there anyway.

Avery Shenfeld: So they certainly, they’ve said it’s balanced, but what you’re inferring is that they’re still paying a lot more attention to risk that inflation ends up being too low rather than too high. And so what does that really tell us then about, we have a December meeting coming up, we have obviously more rate setting dates into 2025. What can we infer after looking at how the Bank of Canada makes these decisions, what the most likely path is for them?

Ali Jaffery: So our call for December is another 50 basis point move that would bring them to the top end of the neutral range that they’ve estimated. And we think that there’s a strong case for the bank to gradually move thereafter into a slightly accommodative stance where we think that the overnight rate will land at about 2.25 and stay there for a while so that slack can be fully absorbed.You know, when you look at the broad landscape of Canadian data, it’s suggesting that this is an economy that really needs rate relief. Headline inflation is below 2%, albeit partly because of softer energy prices. The range of core measures, if you take CPI-X in addition to the bank’s preferred core measures, is centered at 2 % already. Obviously, the downside risks are growing. The bank estimates that the output gap is around minus 1%.labor market data is also in line with that now. Commodity prices have come down. So the broad slew of data is suggesting this is an economy that is an excess supply, clearly an excess supply, and needs some support to pick up. And this is without knowing the implications of, at least the explicit implications of what a Trump administration will mean for Canada. So an easing cycle is likely to continue for some time in Canada.

Avery Shenfeld: So while the Bank of Canada doesn’t give specific guidance, hopefully that is some specific guidance that CIBC Economics is providing to our clients. I think with that we’ll wrap up this edition and thank everyone for joining us. Until next time, we’ll have our eyes on the economy and we’ll be calling it as we see it.

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