Exploring the impact of interest rate changes

Ian Fung, Portfolio Manager, Fixed income, discusses recent BoC and Fed interest rate moves, inflation, employment and their potential effect on upcoming rate decisions.

Summary:

Hi, I’m Ian Fung, and I’m a Senior Portfolio Manager at Empire Life Investments Inc.

We saw elevated levels of inflation in both Canada and the US after the pandemic, and central banks began to address inflation by tightening policy stances in both Canada and the US. To address inflation, Central banks generally tighten real rates. So think of that as the overnight rate less the inflation rate. As inflation went higher, the overnight rate went higher as well to tighten policy. However, as inflation has come down, all else equal, real rates have continued to increase. And so the policy stance has become even tighter.

We’ve started to see central banks begin to ease this year. In Canada, we’ve seen the Bank of Canada cut four times; three 25 basis point cuts and one 50 basis point cut at the most recent meeting. In the US, we’ve had one 50 basis point cut in September so far.

Central banks have gained more confidence in easing given the progress that inflation has made in both countries. We’ve gone from having high single digit year-over-year inflation rates to inflation rates that are closer to central bank targets.

In the US, the US Federal Reserve has a dual mandate, targeting both stable inflation around 2% and achieving maximum employment within that context. Inflation has been trending lower in the US but has remained above the 2% target on both the headline and core, i.e. excluding food and energy basis.

The last mile from 3% to 2% remains the most challenging part of the journey back to target. But in the US, core service inflation has remained elevated, hovering around 4%, suggesting there is more work to be done on inflation. We could also see some acceleration in inflation after the US election, with potential for further fiscal stimulus and other inflationary trends, such as reshoring potentially emerging.

In Canada, The Bank of Canada targets average inflation around 2% with a plus or minus 1% band. Said differently, they’re okay with inflation trending a bit higher or a bit lower if the average ends up around 2%.

Inflation in Canada has made steady progress lower and as of the most recent print, came in at 1.64%. Core inflation has come in a little higher, around 2%. But when you take out food, energy and shelter, which is correlated with interest rates, we’re well below 2%. Also, at the last Bank of Canada meeting, we saw that they mentioned that the risks to inflation are now equally balanced between upside and downside risk. And that contrasts to how it was in previous meetings where the focus was solely on upwards risk to inflation.

Central banks also consider economic growth when evaluating the stance of monetary policy. But we’re starting to see some divergences emerge between Canada and the US. In the US, we have a strong economy that has continued to remain resilient despite higher rates.

The labor market has been easing in the last few months but remains relatively strong when looking at metrics like payroll and hiring data. The unemployment rate has also increased to 4%, which is higher than the lows after the pandemic but relatively consistent with pre-pandemic levels. GDP growth continues to track in the mid threes, with productivity remaining strong.

In Canada, we are seeing the economy slowing with the tighter policy stance. GDP growth has come in below Bank of Canada expectations and has been hovering around the mid ones this year. The labor market has been weakening in Canada as well, with fewer aggregate job gains, a poorer composition, i.e. a greater proportion of public sector jobs as compared to private sector jobs, and an unemployment rate of 6.5%. There are differences between how the two countries calculate unemployment, but if you use the US methodology in Canada, we’re still sitting around 5.7% relative to the US.

So what does this mean going forward? Central banks will generally continue to maintain a data dependent stance as they react to the incoming data. Given the overall progress inflation has made in Canada, and the concern that inflation could undershoot the Bank of Canada’s targets, combined with the weaker growth outlook in the economy, we could continue to see further easing in Canada and the potential of larger than standard cuts similar to the one we saw in October.

Rates could also continue to decline in the US, as policy continues to normalize. But given the overall resilience of the economy, combined with inflation not yet returning to target, we could see a shallower and less intense cutting cycle in the US.

As always, thank you for your support and have a great day.

This video includes forward-looking information based on the opinions and views of The Empire Life Insurance Company and Empire Life Investments Inc. as of October 29, 2024 and is subject to change without notice.

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November 15, 2024