Bank of Canada Preview: (Mis)Guiding Markets

The Bank of Canada’s last policy rate announcement sparked a sharp selloff in fixed income. In all likelihood, central bankers didn’t intend for the market to price in almost two and a half rate hikes, but that was the consequence of the illustrative high oil price scenario presented in the April Monetary Policy Report. Six weeks after publication, it’s clear that current conditions don’t support that sort of monetary tightening and the Bank of Canada will firmly hold its policy rate steady at 2.25% next week.

From our vantage point, the market is still mispriced. With measures of underlying inflation remaining tame and the economy struggling to avoid recession, there’s little scope for central bankers to raise rates over the next few months. All signs point to a classic demand shortfall in the economy—albeit with some moving parts on the supply side too. As a result, the Bank of Canada’s Governing Council no longer needs to be preoccupied with the policy trade-offs associated with a high-inflation, low-growth economy. The group can instead focus on what may be needed should demand deteriorate further.

Aside from the fundamental weakness in the economy, the risk of a messy CUSMA negotiation is underappreciated. A negative CUSMA outcome is the single greatest risk to the Canadian economy. It’s very likely that the US, Canada and Mexico won’t agree to a 16‑year extension of the deal by the July 1 deadline. That doesn’t necessarily spell disaster, given that CUSMA would still be in force, but it does point to a prolonged period of uncertainty during which President Trump could inject volatility.

With that in mind, the Bank of Canada will need to strike a more balanced tone in its communiqué. Doing so will include acknowledging the weakness in the economy as well as highlighting the limited pass-through from higher oil prices to other goods and services prices.

Central bankers should refrain from reiterating that “there may be a need for consecutive increases in the policy rate.” In April, the Governing Council was at pains to explain that the illustrative high oil price scenario was not a full-blown alternative scenario with all of the associated modelling. Instead, it was more like a thought experiment meant to sketch out a unique situation. That nuance was evidently lost on markets, which swiftly priced in tighter monetary policy and turned an act of transparency into another communications misstep. Traders should beware that the Bank of Canada has a history of misguiding markets.

But we don’t expect central bankers will need to cut rates either. Our baseline forecast still includes a boost from fiscal policy, a fading headwind from tariff uncertainty and a return to positive population growth towards the end of this year. All else being equal, the economy is expected to recover from its current malaise without any monetary support. However, should the CUSMA negotiations fall apart, Canadian central bankers will need to respond with lower rates, and all this talk about consecutive rate hikes will look even more ill-founded.