Hot U.S. inflation signal throws Bank of Canada a curveball

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The Bank of Canada‘s upcoming interest rates decision just got more complicated after United States economic data out this week showed growth slowed while inflation remained elevated.

U.S. gross domestic product came in at 1.6 per cent for the first quarter, missing Bloomberg estimates for GDP of 2.5, and slowing significantly from the 3.4 per cent annualized rate recorded in the last quarter of 2023. Meanwhile, the U.S. Federal Reserve’s preferred gauge of core inflation climbed 0.3 per cent in March and 2.8 per cent year over year, causing markets to push predictions for the central bank’s first interest rate cut out to December, with some now forecasting no cut at all in 2024.

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The possibility of increased hawkishness south of the border poses a wrinkle for the Bank of Canada — which many expect will cut rates in June — due to worries that too wide a spread between interest rates here and in the U.S. could hurt the Canadian dollar. That in turn would make it more expensive to buy goods from the U.S., Canada’s largest trading partner, reigniting the inflation the Bank of Canada hoped to cool.

For the moment, at least one currency watcher doesn’t think the June rate cut will be derailed by the U.S. data. It’s the subsequent cut he believes is in question.

“This shouldn’t really change the outlook for the BoC come June, with the bank still likely to cut rates given the economic resiliency and inflation persistence in the U.S. has yet to be imported to Canada,” Simon Harvey, head of currency analysis at Monex Europe Ltd., said in an email. “That said, while the BoC outlook remains clear in terms of domestic data, the risk of the Fed not cutting until December, if at all this year, definitely complicates matters beyond June.”

Following a June cut, Harvey said it’s possible that Bank of Canada officials will take a break at the July interest rate meeting “to relay a more cautious message to markets.”

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The minutes from the Bank of Canada’s summary of deliberations indicated that the bank could cut one time and then pause to make sure inflation was still slowing reliably.

The Bank of Canada has yet to give any “clear guidance” on its thinking about the trajectory of interest rates, but Harvey thinks the statements made by European Central Bank (ECB) officials provide clues to the mindset of their counterparts in Canada.

The ECB is expected to start cutting interest rates at its next meeting on June 6 as inflation has continued to slow.

ECB President Christine Lagarde has said the Frankfurt-based central bank is data-dependent, not Fed-dependent. Some policymakers have cautioned, however, that the longer there is a gap between the two, the greater the impact will be.

“We’re seeing ECB policymakers respond to market developments by stressing that the easing cycle is unlikely to be continuous given the implications this has with the Fed remaining on hold,” Harvey said.

Royce Mendes, managing director and head of macro strategy at Desjardins Group, doesn’t think the U.S. GDP data will have an impact on when interest rates can start falling in Canada.

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“The key variable to watch is the currency,” he said in an email. “If the loonie depreciates too much, that would suggest that monetary policy divergence is reaching its limit.”

Despite a possible hold in July, Harvey at Monex said the expectation there is for four rate cuts this year: In June and then “three times from September as inflation risks breaking below two per cent.”

Markets have priced in two Bank of Canada rate cuts this year, according to Bloomberg data.

• Email: [email protected]

— with additional reporting from Bloomberg News

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