The week in the markets -
April 14, 2023

Will inflation crack before the economy?

The Bank of Canada held its benchmark interest rate at 4.5% on Wednesday, pausing its year-long campaign to increase borrowing costs, while leaving the door open for further rate hikes if inflation doesn't slow as quickly as expected. The BoC expects inflation to fall to 3.0% by the middle of the year, which is in line with our model of 3.6% by summer.

As inflation in Canada subsides, the next move for the BoC could be a rate cut; however, the statement from Governor Tiff Macklem dampened hopes for a cut until the latter half of the year. The central bank's primary concern appears to be ensuring that inflation falls to its target, rather than the potential for a recession in Canada. The central bank’s statement mentioned that "getting inflation the rest of the way back to 2% could prove to be more difficult," which was especially noteworthy, indicating that rates will stay where they are for the time being.

The statement acknowledged potential weakness in the U.S. and Canadian economies but maintained a firm stance against inflation. It's a game of chicken, pitting the economy against inflation to see which will give in first. The BoC is betting on a strong job market to give the winning edge to the economy.

In the U.S., the Consumer Price Index (CPI) was released, which increased 0.1% month-over-month for March, slightly below the expected 0.2%. Year-over-year inflation came in at 5%. Core CPI, which excludes food and energy, rose by 0.4%, in line with expectations. CPI data was generally positive, as energy inflation turned negative, food inflation stabilized and shelter inflation cooled. It appears the U.S. Federal Reserve is on the right path to bring down inflation given the headwinds of a strong labour market. The hiking cycle will only cease when the economy experiences a significant slowdown, which is ironically the most efficient way to eliminate inflation. Our view is that the Fed is likely to pause rates, but market sentiment seems ambivalent. We note that although core inflation persists, the primary drivers in recent months are weakening.

The data does not yet account for post-banking-stress factors and potential tightening of credit conditions, which is why we believe the Fed might become more patient. A cautious Federal Open Market Committee (FOMC) may opt for a higher-for-longer posture to keep consumer inflation expectations from rising as we look at the potential drag on headline inflation from the recent production cuts announced by OPEC+. Fed officials are grappling with the challenge of curbing inflation, while stabilizing the banking sector. We will be paying close attention to the upcoming earnings season, which started this week.

While we don't believe rate cuts are necessary yet, the longer central banks hold firm on rates, or even current rate messaging, the more prone it is to a policy error.