Playing Not to Lose

After cutting rates another 25 basis points in October, Canadian central bankers made a bold statement: they claimed that they now felt rates were low enough to return the economy to full health. With the policy rate at the lower end of their estimated neutral rate range—and still higher than its peak of 1.75% between the Global Financial Crisis and the pandemic—it’s difficult to see how central bankers can have any confidence that the current 2.25% interest rate setting is low enough to heal the ailing economy. Despite the latest strong labour force survey and GDP figures, Canada's economy still looks fragile.

But reading between the lines of the October Monetary Policy Report, it seems as if something else is at play. Central bankers are very afraid of another bout of inflation. So rather than being confident that they have done enough, they are really saying that they have done as much as they think they can.

Former Bank of Canada Governor Stephen Poloz recently said that the institution was in “risk-management mode.” A sports analogy might be even more apt. It looks like the central bank is playing not to lose rather than trying to win.

The COVID-induced inflation spike appears to have scarred those in the institution. With very little evidence outside of anecdotes, central bankers are now explicitly building in an additional push on inflation from Canadian businesses reorienting supply chains and seeking out new markets to sell their wares. There’s no doubt that this is an upside risk to the inflation outlook, but to build it into the base case forecast is jumping the gun. Most measures of underlying inflation point to benign conditions.

 What central bankers don’t seem to be giving enough weight to in their calculus is the risk that interest rates at these levels will choke off a prospective cycle of business investment. The federal government has high hopes for crowding in private capital and has made clear strides to spur business investment. Separately, the AI revolution south of the border may soon begin spilling over into Canada more clearly, as firms figure out how to operationalize the tools that have been developed. The latest productivity numbers show that businesses have also begun to adapt to the new trade dynamic with the US. Firms have become leaner, but production is still growing. It would be a shame if central bankers snuffed out these prospects.

Because the Bank of Canada was so clear and forceful in its messaging (outside of the obtuse language suggesting that they can change their mind if conditions change), we are no longer forecasting any more cuts for this cycle. We expect the Bank of Canada will maintain the language from the last statement about the current level of rates being appropriate. However, for the next six months or so, until fiscal policy becomes a more important player, the Bank of Canada is the only game in town for the economy. If evidence emerges that their cost-push inflation theory has led them astray, they will need to change tack quickly. There’s too much at stake to delay further easing unnecessarily. They need to play to win.