Understanding why the BoC cut, the risks they've taken on, and what could motivate another jumbo cut at the next meeting
The Bank of Canada’s decision to cut interest rates by a further 25 basis points yesterday might have been widely expected, but it came in the context of a tariff threat already wreaking havoc on the Canadian economy. In the decision announcement, the Bank of Canada explicitly cited tariffs and the damage already done by uncertainty around their scale, scope, and timing. It’s a threat that leaves the BoC treading a difficult line between the growth shock and potential short-term inflationary impact that tariffs could have. One analyst, though, says that we can now expect a clear bias towards growth in BoC policy.
BeiChen Lin, senior investment strategist and head of Canadian strategy at Russell investments, explained why the BoC elected to cut again yesterday. He highlighted the tariff threat in the context of other motivations for this tariff cut. He explained some of the risks that the central bank may be taking on, including inflation and a weaker CAD, while driving home the view that BoC Governor Tiff Macklem appears willing to take those risks on. If the trade war persists, Lin says, investors may come to expect a larger cut than is currently being priced in by bond markets.
“We believe that if these tariffs were in place for a protracted amount of time, it could cause the Canadian economy to most likely tip into a recession. So I think that the Bank of Canada is going to be data dependent, but also at the same time, given the elevated amount of economic risks, I also think that the Bank of Canada might have to cut rates by more than what the market is currently anticipating,” Lin says. “If you look at the pricing for April markets right now, are debating, do they need to cut in April or stay on hold? But I think the better question is, do they go by 25 basis points, or 50 basis points?”
Beyond the tariff threat that seems to have spurred this cut, Lin notes that the Canadian economy was already on somewhat fragile footing. While Q4 headline GDP growth numbers surprised to the upside, the unemployment rate is still 1.5 per cent above its 2023 lows and February jobs numbers showed stagnancy. While tariffs have played a key role in yesterday’s cut, the wider context of economic weakness factors in as well.
In targeting the potential growth shock of tariffs with a cut, there is the risk of running inflation hotter. Tariffs inherently pose a dilemma for central banks as they can both weaken growth and cause an inflation shock. Lin notes, however, that tariff-induced inflation amounts to a one-off price increase rather than a trend towards higher prices. That shock would likely be absorbed in the medium and long-terms. He believes that this gives enough cover for the Bank of Canada to cut rates without undue worry about spiking inflation, especially as the Canadian economy risks falling into a recession — which tends to have a disinflationary impact.
The other major concern cited as the Bank of Canada’s cutting cycle has continued is the weak state of the Canadian dollar, especially when compared to the US dollar. While CAD has borne the brunt of tariff impacts, the widening gap between US and Canadian monetary policy has also impacted CAD’s value against the USD. Lin, however, argues that the BoC’s focus is more on the stability of the dollar than on its strength against another specific currency.
Lin acknowledges, however, that monetary policy is a uniquely unwieldy tool for managing the impact of tariffs, because of their dual hit to inflation and growth. He sees opportunity in the Canadian bond market, however, noting that the Bank of Canada is likely to make supportive decisions for Canadian bond prices simply because their focus will be more on growth than inflation.
“You are unable to have a monetary policy that both supports growth, but at the same time also puts downward pressure on inflation,” Lin says, “If we do get a protracted trade standoff between Canada and the US, the Bank of Canada, unfortunately, is going to have to make this uncomfortable choice as to which of the two it wants to focus in on a little bit more. And from my perspective, I think even if there is a temporary rise in price levels as long as medium term and long term, inflation expectations are still well anchored. I think the Bank of Canada is going to focus in more on the downside risk to growth, rather than the potential for that temporary boost in price levels.”
