Why Bank of Canada is unlikely to cut interest rates

Markets remain over-optimistic, says Scotiabank economist

Why Bank of Canada is unlikely to cut interest rates

Most economists surveyed by Reuters believe that the Bank of Canada will maintain its benchmark interest rate at 4.5% through 2023, with a smaller minority currently anticipating an interest-rate drop by year's end, according to a poll conducted a month earlier.

Despite Canada's economy and job market exceeding projections, markets still anticipate cuts of more than 50 basis points. By surpassing forecasts and creating 21,800 new jobs in February, the Canadian economy placed pressure on the central bank to reconsider raising rates after it had previously stated it planned to terminate its year-long tightening campaign. 

Concerns about stress in the U.S. and European banking sectors last year fed this anticipation. BoC Deputy Governor Toni Gravelle stated in a speech last week that the Canadian banking sector had a well-earned reputation for stability on the global stage, implying that policymakers are more concerned about inflation and the state of the economy.

"The Bank's mandate to promote the stability of the financial system means that we're ready to act in the event of severe market-wide stress and provide liquidity support to the financial system," Gravelle said in a Reuters report.

The Bank of Canada (BoC) was the first significant central bank to halt its relentless cycle of rate hikes and enter what it terms a conditional pause in March. The overnight rate will remain at 4.5% on April 12 according to all 33 economists surveyed from March 31 to April 6.

Of the 31 forecasts, 23 predicted that the rate will not change for the remainder of 2023. By year's end, only seven respondents — down from 13 in a poll conducted a month ago — expected at least one 25-basis-point rate drop.

"In my view, central banks are likely to set a higher bar against easing than market participants ... The plague that has driven thinking (is) that they can't possibly hike because, gosh, that might damage growth, when that's the point," Derek Holt, head of capital markets economics at Scotiabank, said, adding that the Canadian economy's fundamentals do not sustain the current market expectations for rate reduction later this year.

According to the most recent BoC business outlook survey, inflation is now running well over the bank's 2% aim at 5.2% and is not anticipated to drop below that level until at least 2025. In comparison to the earlier forecasts of 0.5% and 1.5%, the economy is projected to grow by 0.7% this year and 1.4% next, respectively. In the most recent quarter, it was estimated to have risen by 1.7%.

Although being positive developments for the oil-exporting economy, the recent expansionary government budget and the recent spike in oil prices might complicate the BoC's task by pushing inflation higher than the central bank desires.

Inflation in 2023 would likely be greater than expected, according to 10 out of 13 analysts. Eighteen experts were split equally on whether the Bank will raise rates once more or decrease them this year.

According to a second Reuters survey, the Canadian currency is expected to strengthen over the course of the coming year on forecasts that the export-driven economy would escape a severe landing and that the U.S. dollar will decline as the rate differential with its peers narrows.

"If momentum continues to remain strong, that could be something that pushes the BoC towards tightening again later this year," Robert Both, macro strategist at TD Securities, said. "The current level of inflation and signs of a rebound in Q1 GDP growth are something that are going to make it very difficult for the BoC to cut in the near term."