Bank of Canada Preview: It Was All a Dream

As we wrote earlier this summer, the firmness seen in activity and price data was a mirage—an optical illusion caused by tariffs that fooled some analysts into believing they saw economic resilience and sticky inflation in Canada. Other than avoiding some of the worst-case trade war scenarios, there’s been little to cheer about regarding the economy. Moreover, there’s been even less to worry about regarding inflation. As the central bank shied away from providing monetary support this summer, the economy has steadily deteriorated and inflation has normalized.

The weakness that some economists had mistakenly identified as isolated in trade-exposed sectors has, as we expected, spread to non-trade-exposed industries. While goods-producing sectors have borne the brunt of the pain, the data have shown a deterioration across a number of services industries. The share of sectors with positive year-over-year employment growth has fallen to very low levels. Similarly, the share of industries with positive 3‑month GDP growth has also declined further (graph).

Back in May, our detailed analysis of consumer prices led us to believe that the pickup in core inflation measures seen earlier this year was nothing more than an aberration. Moreover, to the extent that Canada’s retaliatory tariffs were boosting consumer prices, we found that the impact had been consistently fading since peaking in April. Subsequently, the 3‑month annualized rate of the Bank of Canada’s core inflation measures slowed to an average of just 2.4%. The government’s decision to remove most retaliatory tariffs makes inflation even less of a worry, with price growth likely tracking closer to the Bank of Canada’s “de-escalation” scenario.

It’s no wonder then that analysts in the “no cut” camp have been revising their projections. Members of the Bank of Canada’s Governing Council who had mistakenly argued that the economy would be recovering by now or those who were spooked by the prospect of tariff-induced inflation must now also revisit their assumptions. The debate has shifted away from whether or not to ease monetary policy—a 25‑basis-point cut is largely baked in for next week—but rather by how much the Bank of Canada should lower rates. Our terminal rate projection of 2.00% embeds three 25‑basis-point cuts, still slightly more aggressive than the updated consensus of forecasters and what’s currently implied in market pricing.

In cutting rates 25 basis points on September 17, the Bank of Canada won’t endorse any particular rate path. However, in their typical intentionally vague communications, Governing Council is very likely to leave the door wide open to another rate reduction in October. As a result, we see market pricing moving to incorporate a greater chance of reaching a 2.00% policy rate. The balance of risks has shifted, and markets will likely begin thinking more about downside scenarios for both growth and inflation after hearing from a more dovish central bank.