The “four pillars” the Bank of Canada says it will use to measure progress against inflation and guide interest rate decisions have already fallen into line, argues one analyst, blunting the central bank’s hawkish warning that it will hike again if price pressures don’t relent.
In its Sept. 6 decision to hold rates at five per cent, the central bank warned further hikes depended on “excess demand, inflation expectations, wage growth and corporate pricing power.”
“Well, excess demand has been eliminated, five-year inflation break-evens are well-anchored around two per cent, sequential momentum in wage growth has come to a screeching halt, and margins continued to compress throughout Q2,” said Jay Zhao-Murray, an analyst with commercial foreign exchange company Monex Canada, in a note following the release of the central bank’s decision.
Zhao-Murray broke down each of the measures to make the case that the Bank of Canada has achieved its goal of slowing the economy and inflation with its previous 10 rate increases.
Excess demand
Zhao-Murray said the case that “excess demand” persists is a hard sell given that second-quarter GDP contracted 0.2 per cent, well below the central bank’s projections in July for 1.5 per cent growth.
The Monex Canada analyst also noted that growth is currently running well below of the central bank’s estimated range for potential GDP growth of between 1.4 per cent and three per cent.
“The BoC will undoubtedly need to downgrade its growth forecasts in the next Monetary Policy Report, and it will struggle to argue that excess demand still lingers in the economy,” Zhao-Murray said.
Inflation expectations
The picture is a bit “murkier” when it comes to inflation expectations, Zhao-Murray said, noting that the most recent readings from the central bank date back to the first quarter.
In the absence of other data, the analyst pointed to the break-even inflation rate — the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity — to get a read on expectations around pricing.
The most recent break-even reading is 2.05 per cent, just slightly off the Bank of Canada’s target inflation rate of two per cent.
“Its relative stability throughout 2023, suggests that inflation expectations are firmly anchored and on target,” Zhao-Murray said.
Wage growth
The Bank of Canada cited year-over-year wage growth, currently at four to five per cent, to sound the alarm on pay inflation.
However, there are signs gains in wages are slowing.
Zhao-Murray said the three-month moving average for wages contracted an average of 1.7 per cent annualized. Actual wages, he said, are also running below their April peak of $38.33 per hour.
That led to the unemployment rate rising in July to 5.5 per cent.
“With population growth being abnormally high and hiring intentions declining, we anticipate wages to come under further pressure from both the supply and demand sides of the labour market,” the analyst said.
Corporate margins
The operating and profit margins of TSX-listed companies are declining, argued Zhao-Murray.
While acknowledging there is no data showing what is happening at private companies, he said he expects more pressure on margins as consumer demand slows.
To be sure, margins remain historically elevated.
The profit margin for TSX companies was 11.7 per cent on Sept. 5, off a high of 14.3 per cent in June 2022. The average profit margin for the period from March 2010 to now is roughly 10.4 per cent.
“The trend is encouraging for core inflation given that price competition for market share will become an even more prevalent theme as we round out the end of the year,” Zhao-Murray said.
Data galore
In the wake of the Bank of Canada’s hold, several economists expect the next decision, scheduled for Oct. 25, to be data dependent.
From now to the end of next month, the calendar is chock-a-block with economic releases including another GDP report and two inflation and two jobs reports. Also, the central bank will release new editions of its Business Outlook Survey and Canadian Survey of Consumer Expectations for the second quarter.
“We continue to expect no further hikes this year, but the risks to our call tilt to the upside and are concentrated around the October meeting,” Zhao-Murray said.
Canada’s slowing real estate sector has been granted something of a reprieve by the Bank of Canada, after the central bank chose to hold its policy interest rate at five per cent after casting a chill over the housing market with two consecutive rate hikes to start the summer.
Mortgage strategist Robert McLister cautioned that the Bank of Canada’s warning should not be dismissed.
“If consumer inflation expectations tick meaningfully higher, I have no doubt the Bank of Canada will hammer them back down with at least another quarter-point hike, despite a shrinking economy,” McLister said in an email. “That’s not my prediction, but it’s a distinct possibility.”
