With Tariff Threats and Prorogued Parliament, the Bank of Canada Was Right To Cut Rates Again

Published in The Globe and Mail.

After two cuts of 50 basis points at its last two announcements, the Bank of Canada cut its policy rate by 25 basis points on Wednesday. (A basis point is one-hundredth of a percentage point.) If there were no massive trade threat coming from south of the border, it’d be unclear whether a cut this time around would have been necessary. However, in the presence of that threat, the bank was correct in choosing to take out some insurance for the Canadian economy.

It is important to first look at what the numbers tell us.

Start with the bank’s target – 2 per cent headline inflation. The most recent reading in December was 1.8 per cent, similar to the 1.9 per cent in November and 2.0 per cent in October. The slight drop was due to the GST holiday, but inflation was only slightly above 2 per cent if we remove the impact of cutting these kinds of indirect taxes. The current data seem to suggest the economy is operating in a such a way that inflation is comfortably in and around its target.

Other indicators of inflation seem to support what we see. Because some of the components that make up headline inflation can be quite volatile, the bank looks at inflation measures that better capture the underlying trend in price growth. While the bank’s two preferred measures have remained stubbornly high, with Consumer Price Index Trim at 2.5 per cent and CPI Median at 2.4 per cent, they have both fallen over the last couple of months. Plus, the percentage of core CPI components that have grown by more than 3 per cent – the top end of the bank’s 1-3 per cent inflation target range – is lower today than the average over the period from the beginning of 2000 to the end of 2019 (before COVID-19 hit).

The real economic data are more difficult to read. Retail sales were stagnant in November, but according to Statistics Canada’s flash estimate, they rebounded in December, likely due to the GST tax holiday. The jobs report released by Statistics Canada on January 10 was quite strong, as the Canadian economy added the most jobs in one month (December) in almost two years.

The combination of all this data would make us pause in arguing for another rate cut, since 3.25 per cent – the rate before the cut – was within the bank’s estimate of the neutral rate range, 2.25 per cent to 3.25 per cent. This range is where the overnight rate should sit if the economy is operating at potential and inflation is sustainably at 2 per cent.

However, there are two major risks to Canada’s economic outlook that are on everyone’s minds: the threat of significant tariffs imposed by the Trump administration, and the lack of a functioning Parliament, which has been prorogued until the end of March.

The Economic Policy Uncertainty index, by scholars at Stanford University, Northwestern University, and the University of Chicago, shows a level of uncertainty for Canada that is unprecedented (except for briefly during the early days of the pandemic). The Parliamentary Budget Officer’s report on the fall economic update states, “Given the uncertain and volatile global context, the Government’s economic scenarios downplay risks.”

The heightened uncertainty is unlikely to resolve before the next federal election, and uncertainty is deadly for business investment. And we were at a lousy starting point to begin with. Gross fixed capital formation in real terms is less today than it was in 2014. It has been flat during this entire period except for a dramatic drop in the second quarter of 2020. In the bank’s most recent business outlook survey, 40 per cent of firms expected negative effects as a result of the new U.S. administration.

Against such massive uncertainty, one approach is to wait and see how things play out – do tariffs come in at 25 per cent, do we retaliate, does the exchange rate act as a shock absorber? The answers will have an impact on the economy and inflation. Another is to take out some insurance. As we mentioned, at 3.25 per cent, its policy rate was at the top of the neutral rate range. By lowering it, it remains in the range, so as to not overheat, but buys a little extra room to help the Canadian economy deal with these threats.

Jeremy Kronick is Vice-President, Economic Analysis and Strategy and Director of the Centre on Financial and Monetary Policy at the C.D. Howe Institute, where Steve Ambler, professor of economics at Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy.