Could rising US inflation spell trouble for the Bank of Canada?

By Fergal McAlinden

There were few shocks in the Bank of Canada’s decision last Wednesday to keep interest rates unchanged – but there was a surprise on the same day south of the border as US inflation unexpectedly ticked upwards by more than expected.

The core consumer price index in the US, which excludes the cost of food and energy, increased by 0.4% in March compared with the previous month and 3.8% on a year-over-year basis in a development that called into question the prospect of an imminent interest rate cut by the Federal Reserve.

It also raised a quandary for the Bank of Canada – namely, whether the Canadian central bank can afford to start bringing rates lower if its US counterpart remains on hold.

Sal Guatieri (pictured top), director and senior economist at BMO Capital Markets, told Canadian Mortgage Professional that while the Bank had struck a measured tone in its latest announcement, it would undoubtedly be monitoring the US outlook carefully.

“It seems the Bank is a little more calm, confident that [Canadian] inflation will hit the target in 2025,” he said. “And it appears a June rate cut may still be on the table, assuming the next two CPI reports show further progress.

“The one issue, of course, is in light of another very disappointing US inflation report, the Bank of Canada’s hands could be tied by a weaker currency given the possible delay in Fed easing.”

Pushing ahead with rate cuts while the Fed keeps its own funds rate steady could prove a dangerous game for the Bank of Canada, according to Guatieri.

“It would be an issue largely for the Canadian dollar, and then possibly for the inflation outlook because if the Canadian dollar weakens too rapidly, it would push up import costs and then inflation,” he said, “so it would be in the Bank of Canada’s mind.”

Housing market a key consideration for the Bank as it mulls rate cut

While the Canadian economy is performing sluggishly at present, the Bank’s statement last week indicated its expectation that economic growth would pick up in 2024, partly as a result of “robust” demand for housing.

Guatieri said the Bank will also be watching the performance of the housing market with interest as it weighs up whether the time is right for a rate cut – although a mild uptick in activity likely wouldn’t be a cause for concern.

“I think the Bank of Canada definitely has an eye on the housing market,” he said. “I would presume as long as the expected recovery in the market, including home prices, is fairly gradual and modest, it’s not really an issue for the Bank of Canada.

“There could be a problem, though, if the Bank of Canada begins to cut interest rates and we see the housing market recover too quickly and house prices shoot higher – because that, again, would fan inflation pressures.”

What impact will the Bank’s latest decision have on the market?

The central bank has now kept rates on hold for six consecutive decisions – with the prospect of at least one cut down the line in 2024 – but Guatieri said its latest move is unlikely to see activity surge in the Canadian housing market.

“Currently, monetary policy is restrictive,” he said. “Interest rates are relatively high. Mortgage rates are well above long-term neutral or normal levels. And that’s having a dampening effect on the housing market. Affordability was already stretched because of the previous explosion in home prices.

“And affordability nationwide, although it’s largely a BC and Ontario issue, is the worst it’s been in over three decades. So clearly monetary policy has put the brakes on the housing market.”

The question looking ahead, he added, is how quickly the housing market recovers when policy eases and interest rates come down.

“Our general sense is lower rates will help. Strong population growth will help the market recover,” he said. “But that lack of affordability, especially in BC and Ontario, will hold the market back. So we do not expect a V-shaped recovery in either home sales or home prices.”

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