Published on: January 30, 2025
The central banks of both Canada and the United States announced policy rate decisions on Wednesday. Without much surprise, the Bank of Canada (BoC) cut its rate by a further 25 basis points to 3%. On the other side of the border, the US Federal Reserve (Fed) ignored President Trump’s calls for a downward revision, opting instead to maintain its rate at 4.25%.
The BoC Ends Its Quantitative Tightening
The Canadian central bank explains its latest decision by the considerable uncertainty reflected in its Monetary Policy Report. At the root of its concerns is the potential introduction of tariffs by the United States. In a press briefing, BoC Senior Deputy Governor Carolyn Rogers said: ‘The possibility of a trade conflict resulting from the imposition of new US tariffs on Canadian exports could have a significant impact on the Canadian economy, clouding the outlook’.
Here are a few observations made by the BoC in its most recent Monetary Policy Report :
• The Canadian economy grew more slowly than expected in the third quarter of 2024.
• Inflation measured by the consumer price index (CPI) has hovered around 2% in recent months.
• Growth in final domestic demand rose to around 3.5% in the fourth quarter.
• Projections for GDP growth have been reduced to 1.8%.
The content of the report seems to be tainted by a subjective selection of data on wage growth. The data highlighted by the BoC appears to disregard recent inflation dynamics, ignoring the significant difference between the 1.4% total hours worked in 2024 against the 3.0% assumption used by the Bank to calculate potential output growth.
Furthermore, inflation in Canada accelerated to the point where three-month annualized measures rose sharply to well above 3.0%, which is the upper end of the target range. We fully understand that three-month annualized rates are more volatile than year-on-year rates. When inflation is under control, however, it moves above and below the 2.0% target. The current figure of 3.5% implies that this measure needs to fall to 0.5% very quickly to avoid a reflationary dynamic in year-on-year growth rates over the next few months.
From a purely mathematical point of view, a permanently higher three-month annualized inflation rate is a leading indicator of a year-on-year growth rate, and the current gap between these measures represents a staggering 1.5 percentage point. Despite a worrying rise in inflation in the short term, the BoC seems more concerned about the threat to real GDP posed by tariff uncertainty.
The Fed Stands Up to Trump
The US central bank justified its decision to maintain its policy rate by citing the stabilization of the unemployment rate in recent months and the strength of the job market. However, it notes that the FOMC is closely monitoring the risks to both aspects of its dual mandate, against a backdrop of uncertainty about the economic outlook.
At the press conference following the release of the policy statement, the Chair of the Fed, Jerome Powell, said that “there is no need to be in a hurry to adjust our policy” and that monetary policy is “well positioned” to meet the challenges ahead.
The announcement of the Fed’s decision was not supplemented by an update of the economic forecasts. Here are a few observations made by the FOMC at a press briefing:
As the Fed Chair stated today, ‘We look at core inflation data because it is a better indicator of future inflation.’ This is precisely what we do on account of causality. It is not the total personal consumption expenditure (PCE) that causes core inflation, but rather the total PCE that converges towards core PCE. This has always been the case, which is why econometric analyses always resort to core inflation rather than total inflation. There is nothing to extract from a year-on-year inflation rate for energy or food that would help to forecast core inflation.
It should also be noted that Trump’s tariff stance is creating a great deal of uncertainty on the inflation front. However, if the inflation picture brightens and uncertainty over tariffs diminishes, this scenario could prove favourable for the bond market over the course of the year. If we see disinflation in the near future, the Fed will certainly continue to ease its policy.