BoC needs to be the driver of stimulus for this underperforming economy: Lovely on rate decision

Key Concepts

• Bank of Canada (BoC) Interest Rate Cut: Reduction of the core interest rate by 0.25 percentage points to 2.25%.
• Excess Capacity/Slack: Underutilization of economic resources, including factories and labor.
• Tariffs: Taxes imposed on imported goods, significantly impacting Canadian sectors like steel, aluminum, autos, and lumber.
• Geopolitical Uncertainty: Unpredictable global political and economic landscape, widening the range of possible economic outcomes.
• Consumer Price Index (CPI): A measure of inflation, expected to remain near 2%.
• Canadian GDP: Gross Domestic Product, the total value of goods and services produced in Canada.
• Neutral Rate of Interest: A theoretical interest rate that neither stimulates nor restrains the economy. The BoC's neutral range is estimated to be 2.25% to 3.75%.
• Monetary Stimulus: Actions taken by a central bank to increase the money supply and lower interest rates to boost economic activity.
• Fiscal Stimulus: Government actions, such as increased spending or tax cuts, to boost economic activity.
• Productivity Crisis: A prolonged period of stagnant or declining output per worker hour, impacting long-term living standards.
• Flow-Through Shares: A tax incentive for investors in resource industries.
• Structural Transition: A fundamental shift in the economy's composition or operation.

Bank of Canada's Interest Rate Reduction and Economic Outlook

The Bank of Canada has reduced its core interest rate by 0.25 percentage points, bringing it down to 2.25%, as anticipated by economists. This move is a response to persistent excess capacity within the Canadian economy, meaning that factories and labor are not being utilized to their full potential.

Governor Tiff Macklem highlighted the severe effects of tariffs imposed by the US administration on key Canadian sectors, including steel, aluminum, autos, and lumber. Despite acknowledging the uncertainty in the global economic environment, which he described as having a wider range of possible outcomes than usual, Macklem expects opposing pressures on the Consumer Price Index (CPI) to keep inflation near the 2% target. This would represent a relatively benign interest rate environment within the Bank's target range.

Macklem quantified the economic cost of the US tariff war, estimating that Canadian GDP will be 1.5% lower by the end of next year compared to a pre-tariff outlook. He further stated that the negative impacts of US tariffs are becoming more evident and that the weakness in the Canadian economy marks a "structural transition." The Bank of Canada is forecasting very modest growth for the remainder of 2025.

Expert Analysis of the Rate Cut and Economic Strain

Warren Lovely, Managing Director and Chief Rates and Public Sector Strategist at National Bank Financial, commented on the Bank of Canada's decision. He noted that this is the second consecutive rate cut, a move reminiscent of the early 1990s. However, Lovely emphasized that there is "nothing to cheer about" as the rate reduction is a consequence of the economy being under immense strain.

Lovely elaborated on the concept of slack in the economy, referring to underutilized resources (both physical and human capital) and the ongoing geopolitical uncertainty. He argued that these factors necessitate taking out "interest rate insurance" by lowering rates. The current rate of 2.25% is now at the lower end of the notional neutral bound.

Explanation of the Neutral Rate

Lovely explained the neutral rate of interest as a range (2.25% to 3.75%) where monetary policy is neither stimulating nor restraining the economy. By moving to 2.25% in two back-to-back meetings (from 2.75% previously), the Bank of Canada is now operating at the low end of this neutral range, essentially needing to provide monetary stimulus.

Supporting Evidence for Stimulus

Lovely cited several reasons for the need for economic support:

• Weak labor market.
• Challenged export outlook.
• "Death of a thousand sectoral tariff cuts" impacting the industrial sector.

The Bank of Canada has lowered its GDP growth forecast to just 1.2% this year and 1.1% next year, indicating near-zero growth, which Lovely characterized as "lackluster."

Trade Uncertainty and its Economic Impact

Lovely expressed skepticism about near-term certainty on trade, despite efforts in Asia to secure new markets and mend fences with the US. This persistent uncertainty, he argued, creates lackluster economic conditions by sapping business confidence for investment and deterring consumers from making large purchases, such as homes. This pullback in spending directly impacts GDP growth and hiring. Consequently, limited growth and continued labor market weakness are expected.

Currency Devaluation and Stimulus Options

The discussion touched upon the idea of competitive devaluation of the currency by Canada to boost exports. While acknowledging that the market is already pushing the Canadian dollar lower due to concerns about global economic growth and trade protectionism (which lowers commodity prices, impacting the Canadian dollar as a "pro-currency"), it remains unclear if the devaluation is sufficient.

The consensus is that some form of stimulus is needed for an underperforming economy. This stimulus can come from lower interest rates or fiscal stimulus. The upcoming federal budget is therefore being closely watched.

Federal Budget and Fiscal Policy

A massive deficit, in the tens of billions of dollars, is expected in the federal budget, partly due to increased defense spending in conjunction with European countries. This enlarged defense expenditure is seen as a cost of doing business with the US administration. The government also faces limitations in retaliating with its own tariffs, which reduces tariff revenue.

The federal budget is described as a "transformative" and "one of the more important federal fiscal blueprints" seen in a generation, potentially since the mid-1990s. However, viewers are cautioned to recalibrate expectations regarding immediate fiscal impulse and growth from the budget. While the deficit spending will have an impact, it may take longer to materialize. Therefore, in the short term, the Bank of Canada is expected to be the primary driver of stimulus.

Limitations of Monetary Policy in Trade Wars

Tiff Macklem reiterated that interest rates cannot fix the damage caused by the trade war. The Governor's message is one of collective effort, acknowledging that a central bank is not ideally positioned to lead on geopolitical and trade conflicts. The sectoral damage to businesses and workers requires government intervention to protect vulnerable sectors and create conditions for long-term economic growth. While lower interest rates can help, a concerted effort between monetary and fiscal policy is crucial.

Productivity Crisis and Structural Adjustments

The conversation shifted to boosting per capita productivity, a complex issue requiring painful adjustments. The Bank of Canada's mention of "structural transformation" points to a prolonged "structural productivity crisis," characterized by minimal gains in output per worker hour over the past 5-10 years. This stagnation impacts long-term living standards.

Addressing this crisis requires:

• Lowering regulation.
• Reassessing the tax code.
• Facilitating the initiation and completion of major projects.

The federal budget is expected to provide clarity and a roadmap, but a multi-year or decade-long productivity crisis cannot be solved with a single solution or in a short timeframe. Patience is advised.

Resource vs. Tech Sector Investment

The idea of extending the flow-through share tax incentive, currently available for resource investors, to the tech sector was discussed. While acknowledging the importance of the resource sector to Canada's economy and export base, there's a recognition of the need for a high-tech strategy as well. The argument is not to pick one over the other but to pursue both. Canada's skilled workforce and potential for better regulation and tax incentives could drive growth in the tech sector.

Political Appetite for Radical Government Cuts

The possibility of radical government cuts, similar to those implemented in Argentina by Javier Milei, was deemed inappropriate for Canada at this time. The Canadian economy is described as being on "government life support" due to the private sector's detachment, stemming from a lack of confidence driven by uncertainty regarding engagement with the US and a dependence on that trading partner. This situation places the onus on the government and central bank to drive growth. While government cutbacks are not advisable in the short term, efficiency in government spending is still important.