In long-awaited shift, Bank of Canada cuts its policy rate to 4.75%,

REAL ECONOMY BLOG | June 05, 2024

Authored by RSM Canada

The Bank of Canada’s pivot has finally arrived.

After years of raising interest rates and then keeping them elevated, the Bank of Canada dropped the policy rate by 25 basis points on Wednesday, signaling a new period of recovery and growth.

It was the first rate change for the Bank of Canada since July of last year and the first rate cut in over four years. The rate reduction comes as the world’s major central banks, with inflation having been largely contained, embark on a new regime of more accommodative monetary policy to foster demand and growth.

The Bank of Canada had ample reason to embark on a new cycle of rate cuts: Headline and core inflation measures have fallen below 3 per cent, growth has been flat, and unemployment is rising.

Given the central bank’s dovish statement that acknowledges its significant progress on inflation, another rate cut is likely for July. As long as inflation continues its downward trend, we expect a total of three more rate cuts this year, bringing the policy rate to 4% by the end of the year.

At 4.75 per cent, the policy rate remains more than sufficiently restrictive. Our modified Taylor Rule indicates that based on a decrease in potential growth and the realignment of the labour market that brings the equilibrium unemployment rate down to 5.4%, a policy rate of less than 4 per cent would be appropriate until the economy gets back on its feet.

While a single rate cut will not revive the economy overnight, it signals to consumers and businesses the beginning of a gradual rate cut cycle over the next year and a half. Recovery can begin now and hit full force next year.

In its statement, the Bank of Canada noted that underlying inflation had continued to ease. The headline consumer price index fell to 2.7 per cent in April, marking four consecutive months of inflation under 3 per cent and within the central bank’s preferred rate.

More importantly, the central bank’s preferred measure of core inflation has fallen below 3 per cent. Price increases are no longer broad-based. Clearly, monetary policy worked.

Immigration is slowing with new restrictions on temporary residents, which will limit population growth and help prevent housing prices from jumping too much this year.

The Bank of Canada led the G7 in the rate hike cycle in 2022; now it is once again leading the way, this time with rate cuts. The Bank of England, the Federal Reserve and the Reserve Bank of Australia are expected to all follow suit and begin reducing rates in the next few months.

The divergence from the Federal Reserve will lead the Canadian dollar to weaken, but the effect will be temporary until the Fed begins its rate cut cycle, and it will be worthwhile to help the economy get going again.