Now that the Fed has cut its interest rate by 50 bps, it's time to start speculating about what the Bank of Canada will do on October 16. It should be noted that the Bank is dealing with a very different problem than the one facing the Fed. Indeed, it's facing a problem that the Bank of Canada hasn't seen before.
Core inflation came down a bit to 2.2% y/y in August, but it's been above the 2% target for more than a year now. Moreover, the Bank's measure of the output gap has been positive for at least a couple of years. Put them both together, and it's easy to understand why the Bank's bias is towards increasing interest rates. The only reason they wouldn't would be is if it thought that inflation would come down on its own. The run-up in the CAD-USD exchange rate will slow inflation a bit, but its effect will be modest. The real issue is the extent to which a slowdown in the US will reduce inflationary pressures here.
In previous expansions, the answer would have been "a lot, and soon", so the Bank could be expected to follow the Fed's lead. But things are different this time. Exports (in practice, this means exports to the US) were the driving force behind the 1982-1990 and the 1991-2001 expansions, but they've been a drag on growth in the current expansion, growing only about 2/3 as fast as GDP. The main source of growth has been domestic demand.
Even so, a US slowdown that had the effect of reducing Canadian exports would still bring down inflation. But again, things are different this time, notably the composition of exports. A US recession can still be expected to reduce manufacturing exports, but manufacturing exports are being displaced by energy exports. In previous cycles, this wouldn't matter: a US recession would also reduce oil prices, so Canadian exports would fall anyway. But oil prices are not following the usual script: the US' share of world demand is falling, and world oil supplies are tightening. Even though expectations of a US slowdown are widespread, oil prices are still going up. It may well be that US oil demand will fall, but it will show up as a reduction of oil imports from overseas rather than from Canada or Mexico.
So it's not at all clear to what extent a US slowdown will attenuate inflationary pressures in Canada, which makes the Bank's next move harder than usual to predict. Right now, my expectation is that they will hold off on their tightening bias and keep interest rates steady. If things worsen in the next few months, they'd be forced to reverse an October increase, and the Bank doesn't want to become a source of volatility in the financial markets. Nor do current conditions warrant a rate cut (here I am pointedly ignoring this foolishness): a decision to reduce interest rates would have to be based on the arrival of bad news between now and October 16.
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