Where is Canadian monetary policy headed?

Avery Shenfeld: Hello and welcome to another edition of CIBC Perspectives. I’m Avery Shenfeld, Chief Economist of CIBC. It’s my pleasure today to be joined
by Professor Paul Beaudry, who, for many of you, will be better known as Former Deputy Governor of the Bank of Canada, Paul Beaudry. Paul was a long-time leading
light in Canada’s academic circles. In the field of economics, was a significant contributor, of course, to the Bank of Canada’s decisions over the past years from 2019 to 2023, when he served as a Deputy Governor and also left the bank with a fair bit of interesting research, including some papers he had done in some speeches on the longer-term outlook for where interest rates will settle. All of which, of course, are very interesting topics for our own clients. So, nice to have you with us here, Paul. And thanks for joining us today.

Paul Beaudry: It’s really my pleasure to join you there Avery.

Avery Shenfeld: I think we should get started with the most recent developments, which is the Bank of Canada’s latest pronouncements on interest rates and, of course, the accompanying monetary policy report. Markets did see a little bit of a change in tone from the bank. But given your background there, I’m wondering how you interpreted the overall message that the bank was trying to deliver to market participants?

Paul Beaudry: Well, I think there’s a set of things. First of all, I don’t think many people were surprised with the decision itself. The idea that keeping rates at 5%
didn’t surprise markets. So it’s really much more in the the change in some of the tone. So the pivot from this aspect of wondering whether the bank had been restrictive enough to, how long it has to hold rates, I think that’s important. So it’s really this aspect of, “have rates been high enough?” And there’s generally the view
now at the bank that probably they have been high enough and now we get into this aspect of, “how long?”. That right away opens the idea that, when you change that, then people start talking about cuts. But at the same time, there was a message of, “Well, wait a minute, it’s not kind of quite time to talk about cuts.” So I think we want to break that down in a few pieces of understanding that total message there. The first thing is, “Why the change in messaging?”, and the large part there and coming in both through the speech and the press release and the MPR is in large part the economy’s been moving along the path that the bank has been expecting. So this is the developments are in line with expectations. So that was a bit the idea in the past. If things go that way, we’ll feel more confident. I think the big piece there was really this aspect that there’s a general sense of the economy now being in excess supply. And so this aspect that there’s been enough tightening to bring the economy in that situation, which should favour inflation coming down. But at the same time, why this pushback of saying we’re not ready to talk about rate cuts and everything, is on the flip-side. You really look at the price pressures and they haven’t changed so much. Now, the bank had been predicting that they won’t change so much, so it’s still very much in line with what they have been saying. So in that sense, it’s this consistent message of things are developing as we expected, but this expectation included that a lot of these price pressures might take a while. And that’s what we’re really seeing. A lot of the core measures
haven’t been coming down. There’s this aspect of ‘wage growth’ that’s quite high, especially related to productivity and what we can come back to that and, you know, different measures, expectations, price behaviour, they’re all really moving slowly or not moving too much. And that’s keeping the bank to say, “we’ll need to keep rates at this level for a while and we’ll have to see developments that really get us convinced that the economy is going back to that 2%.”. So in the background, does that tell us somewhere where rates might start coming down? And my breakdown of this is relative to others of how fast things might go. And I think people have very much these different views. If you’re very much someone that thinks the whole thing was, getting excess supply in the system, it’s there. Therefore, rates should try to start cutting. On the flip-side, it’s very much more… and that’s, I’m more in that view of, thinking, “you really have to look at these price pressures and looking at these before you get an idea of when the Bank of Canada might cut.” And if you look at the projection, really, you see and this has been there for a while, it’s mid-2024, they’re predicting that some of these underlying forces in inflation should be coming down. So my impression is they’ll be hesitant to reduce rates until that period, I’d say the mid-year. So I wouldn’t see the potential rate cuts until probably the July decision. So that, they get that aspect, “Is this fall in inflation by midyear really materializing?” If it does, then I think, you know, things will start moving everything. Now, they could move faster if everything actually moves, a lot faster and things, these price pressures disappear. But if they just stagnate as they’re doing now, then I think there’ll be this tendency to at least want to wait until the midyear to get this aspect that they think in the underlying forces. And I’m guessing it’s some of the aspects that they’re thinking, some groups of goods and different things will come down, inflation come down by mid-year. So that’s where we’ll see that aspect. So I would expect no rate cuts until the mid-year except if really developments change on the positive side. But that’s more like a the lucky draw.

Avery Shenfeld: I noticed that they did in their projection, project to pick up on growth in the second half of the year and they attributed that pick up to an easing in financial conditions, which almost sounds like it’s consistent, I suppose, with interest rates in that second half of the year being lower or lower enough to make a difference.

Paul Beaudry: Well, already we’re seeing the easing. So even when they’re staying at 5%, we’re already seeing an easing in financial conditions. We’re already seeing longer-term mortgage rates, for example. You know, those five year rates, they’re coming down different part. So even one, they’re keeping up the 5% level, even without them changing, there is a change in those financial conditions. And there’s this also, come back with the US. There’s also a lot of aspects there, moving to suggest that financial conditions will become a little bit easier. So that pickup and also the exports to the US is being an important part of helping that growth. As we get further down.

Avery Shenfeld: I guess we need them to validate to some extent though, the expectations that have been built in because otherwise those five year rates would move back up again.

Paul Beaudry: Oh yes, for sure. But again, my impression that, that might take a while. So again, we’re waiting. I wouldn’t see quick rate cuts except if we
see some of these real price pressures. So I really do think on the real economy, there really has been this slowdown and again, the recession wording to me is always a little bit like not the best wording, because when you have a lot of population growth, recessions are high hurdle to get. But there’s a real slowdown. When you look at the per capita growth, the Canadian economy is really growing very slowly. We see the unemployment ticking up. So we’re really in a downturn right now. And that aspect is running its way. But you really need this other part of seeing these price pressures fall before. I really think that the bank is going to validate those aspects
that the market thinks is going to happen.

Avery Shenfeld: You mentioned the US and there’s obviously been a huge contrast between big upside surprises in US growth and the ‘near recession’ that we’ve been in, in Canada. Financial markets are actually betting that the Federal Reserve will cut more aggressively this year, obviously looking at their progress
on their inflation measure, versus ours. How do you think that plays out? The tension between the US economy, which doesn’t exactly look like it’s desperate for interest rate relief, but making progress on inflation that we haven’t quite seen as much of in Canada?

Paul Beaudry: I think that’s a really good question, and I really see there’s a really distinct aspect right now. The US is just in a much better position, okay? And the choices they have, and different things. If you look at some of these underlying pressures on prices, they’re really coming down much faster in the US, despite the fact that they’re growing faster. So it’s like they get it, they’re doing it better on both sides there, that things are working very well, despite the fact that the effect directly
on slowing down the economy has been bigger in Canada, we’ve had less or less of that progress on inflation. So you might wonder, “Why, where is this biggest difference?” And I think there’s a few factors, but I think the main factor there is really the productivity factor. So after a period of high inflation, everything, it’s very natural to have a process of catch up of wages and wages increases. And if you look nominally, they’re similar between Canada and the US, but the US has been just getting these ‘productivity surprises’. And so, even at 4% wage growth, you get those productivity surprises, it doesn’t mean it passes through to prices. So you get a dynamic that’s much more positive in the US in bringing in this possibility of a Goldilocks scenario of actually coming down with inflation and really not even getting into a period of really excess supply or anything to get to that point. So I really do think that the US is in a good position, really having the aspect of being able to cut, and I wouldn’t be surprised if they actually cut earlier, even despite this difference in types of tightening. But I agree with you that the cuts might not be as  aggressive that people think. So I wouldn’t be surprised that it goes in that direction. And there really is the aspect that the US economy is doing very well. And so, I think there’ll be a sign of wanting to acknowledge that prices are coming down and bringing interest rates a bit down. But the idea that there’s no hurry, as long as the American economy is growing at the type of rates we’re seeing, there’s not a big reason to take a risk of overheating it. So then it could be that Canada and the US is actually a two very different speeds there, and that often makes tensions and how that will play out on the exchange rate is very intriguing because there’s two different scenarios you could see there and it makes a big difference how it plays out. Suppose the US starts cutting a bit earlier. Exactly, because these price pressures are doing better, and Canada keeps interest rates a bit higher. Exactly, pushing it a bit further out to make sure it sees the price pressures you’re planning. That could be like, “Okay, well, you know, interest rates are a bit higher. That helps the Canadian dollar and everything.” That’s the optimistic view
of how that might roll out. On the flipside, if the market starts saying, “Well, the reason for that difference is the higher inflation in Canada and it’s more entrenched there.” You could see actually pressure on the downside and that feeds back in making it even harder, because if you start getting a bit of depreciation through that,
it starts moving some of those prices. So that’s that’s really that tension we see between the two. And I really think the US is in a nicer, kind of, easier position and Canada has a bit harder choices there. 

Avery Shenfeld: So maybe you should have been on the Fed rather than the bank of Canada, got the easier calls. I want to ask you about why their productivity is so much better, because we could have a whole conversation about that for another day. But let’s turn to, when we do get these rate cuts coming, of course, financial markets not only are placing bets on “when?”, and “how much?”, but, “where to?” Where we’re going to end up. And you did some interesting research at the Bank of Canada as well as a speech on that research that talked about reasons why maybe rates won’t be as low as we think they will be in the coming cycle, or at least not  early as low as they have been in some past decades. So maybe we could look at where do you think we end up after this easing cycle is said and done here.

Paul Beaudry: So I think that’s a huge important question and it’s really important to get an idea of where things are going to end up. And this, coming back, especially thinking about the Fed, how they’ll interpret this. And I think there’s a big gray zone. We have trouble figuring out where things have changed and we’re going to go back to 2019, by the end of 2019. And now think about some of the real rates of thinking about interest rates adjusted for this inflation part, these real rates by 2019 before COVID and everything, we’re down to basically 0%, okay? I really look at those ten year rates. Right now in the market, they’re at the 180 level  or something. It’s a very big change. So that makes the normal rates, this idea of where they could be, somewhere could be like 3.5%, that could be somewhere like that versus 2% before. Now, I don’t think the Fed knows. I don’t think many people know exactly, but I do think the Fed will take that and be cautious. So when we’re thinking about where things might go. You know, the US economy is growing at a good pace and everything. Yeah, they might start cutting, but maybe they’ll aim like once they get to 4%, going down to 3.7%, they might want to slow down and make sure they’re not overheating because maybe that long-term rate is higher and that, there’s enough demand in the US that you don’t move there. So I would expect that there might be cuts there, but not as far and aggressive going further. So once it touches 4%, I think they’ll be this searching and slowly moving down and trying to see where that long run rate is, with the idea that, you know,  it might be more in that 3%, 3.5% for sure, and not back to the two percents were before. Now those type of long real rate conditions really matter also for Canada, it’s kind of  taking that, all those longer type things. So I’d say the same thing of where in Canada we could be going at. But, you know, if the real rates are kind of at, let’s say 1.5% or somewhere between that 2%, then you start thinking, “If we get stuck at an even at 3% inflation, it means we’re not that much in restrictive territory anymore, even at our 5%.” So, there’s a bit of issues that come up, looking further down the line in different, different challenges that might be.

Avery Shenfeld: So just as a follow up on that, you mentioned getting stuck at 3% inflation. I think one of the things economists noted in the prior business cycle really longer than that, was that we had a very easy time actually, not only getting to 2% inflation, but keeping it there. And actually inflation wasn’t that sensitive
to drifts in the unemployment rate. Part of that was ascribed to the fact that, well, we’d gotten so used to 2% inflation, that market participants, businesses could sort of think to themselves, “Well, it’s unlikely that inflation is going to be anything but two.” Now we’ve had, in a period where, for the first time in decades, we had a  substantial length of time where inflation was way above two. Have we let that genie out of the bottle? Is it going to be now more difficult to keep expectations grounded at two because of this one episode, or was this a short enough episode? If we get inflation back to 2% in the next year, year and a half,  will that fade from memory?

Paul Beaudry: I think it’s a really good question. First of all, I completely agree. We went basically almost 30 years of kind of having inflation around two and it wasn’t very sensitive of things. I do want to remind that, if you go back, bringing it down to 2%, was not a non-costly type thing. So if you go back to the early, early 90s, and it was like that late 80s after the big period, it was more floating around 4%, and then there was the idea of bringing it down 2%, and that we could get into
how much it was costly, but it certainly wasn’t ‘not costly’. And so, that aspect wasn’t an easy change. And so, that aspect wasn’t an easy change.

Avery Shenfeld: Very costly.

Paul Beaudry: So making that type of change is not necessarily an easy one. But conditional on making it there, then you stabilize and everything. It’s exactly this part, what you’re pushing, I think, is important. It’s, “How long could it be that throughout these higher rates and start getting a mentality where maybe 3% is like our new normal?”, and that’s the aspect. Now I think the pull down and bringing things back there to two is really aiming well. In the case of Canada, I think it’s going to  be there. So I think the baseline is they’re going to bring it back down. But I do think there is a bad scenario, and much more challenging scenario, where things get stuck at between 3% or 3.5%, or all around 3% or a bit above the target. Then you get exactly into this mentality of whether, you know, we got used to it and we are living with 3%. Everything’s working with 3%, but you know, people don’t like it. It still makes a big difference over time, how fast things change in price even at 3% versus 2%, because it’s 50% more. That aspect starts feeling like, you know, interest rates at 5%.  Like I say, ”if things are going at 3%, and the real rate is more at 1.8%”, we’re not that restrictive. And so you can get a scenario, and this is the most difficult scenario the Bank of Canada could face, would be that, getting stuck 
where people are starting to live and be there with that 3%, and then needing to attack it. Like I say, “I don’t think it’s the baseline scenario”, but I don’t think we’ve ruled it out in the case of Canada. And so, the worst scenario I would see is exactly, by the midyear, we don’t see these price pressures decrease. We see the economy might actually start growing, exactly because of the US certain aspects, people getting used to it. So growth might pick up a bit. Inflation’s not coming down. We get something in that ballpark. What happens to the exchange rate? Do we get a little bit of depreciation and even supports all that part? And then you get into a difficult situation. I don’t want to say, “that’s my baseline”, but I do always keep an eye for bad scenarios because you always want to keep, you know, we have to look at all things, not only the good sides. And so there’s good scenarios too, that could make things faster.

Avery Shenfeld: So, I think our audience is probably hoping for some of those good scenarios to work out. But I think you’ve given us some interesting insights into what could go wrong as well and where we might be headed to in terms of interest rates, not only near-term but longer-term. And with that, I’d like to thank you Paul for joining us. I think our clients will definitely benefit from some of the insights that you brought and hopefully maybe down the road we can do this once again and revisit where Canada actually went in 2024 and how this has all panned out. So thank you for joining us today.

Paul Beaudry: Well, my pleasure, Avery.

Avery Shenfeld: And thanks to our clients for coming online and joining us. And we hope you look forward to other episodes of our series where we’ll try to bring you market moving and insightful information to help you run your businesses and your investment decisions. Thanks for joining us.