Sandrine Soubeyran
Robin Marshall
- Should QT continue if Canadian inflation is retreating towards the 2% target?
- Is policy becoming too tight?
Despite a modest uptick recently, inflation has been falling globally, including in Canada, as major central banks maintain their tightening stances to rein back inflation to 2% targets (Chart 1). Although policy rates have been on hold since August 2023 in Canada, like other central banks, the Bank of Canada (BoC) has continued to implement its Quantitative Tightening (QT) programme, so policy tightening continues. With inflation falling close to target, and a broader slowdown in economic activity, this raises the related question of whether QT should continue. Indeed, this issue will become more acute, if the BoC does move to ease policy rates in the months ahead, given the underlying policy tension between easing rates, while shrinking the balance sheet.
Chart 1: Inflation levels are a long way from their 2022 peaks
Source: LSEG; data to January 31, 2024. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures.
BoC is helped by core inflation moving below headline inflation, unlike the US
Evidence that the BoC is in a more favourable position to consider easing policy than most G7 central banks may be found in Canadian core inflation being lower than headline inflation, at 2.6% vs 3.4% y/y, and is now closer to the BoC inflation target, as Chart 2 shows. In comparison, US core inflation still comfortably exceeds headline inflation, at 4% y/y versus 3.4% y/y.
Chart 2: Canadian core inflation has dropped below headline inflation
Source: LSEG, Bank of Canada; data to January 31, 2024. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures.
Furthermore, easing in Global Supply Chain Pressure signals how demand for tradeable goods has fallen globally, after the measure returned to its mean in January. So, although there has been some limited impact from disruption of Red Sea shipping routes, indices like the NY Fed’s, only show mean reversion in supply chain pressure and costs, as Chart 2 shows.
Chart 3: Global supply chains have remained close to the mean
Source: LSEG, data to January 31, 2024. The Federal Bank of New York, standard deviation from the mean. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures.
Textbook growth slowdown from higher rates supports policy easing…
If inflation is retreating towards the 2% target, helped by lower goods inflation and normalisation in supply chains, is monetary policy becoming too tight, given the BoC’s dual mandate to achieve 2% inflation and “maximise sustainable employment”?
Recent economic data suggests this may be the case. Canadian GDP contracted by 1.1% in Q3, due to weakening consumer spending, investment, de-stocking and slower employment growth. Lower inflation rates also mean real rates increase, with unchanged nominal interest rates, tightening policy further, unless the BoC responds by lowering rates (a problem that becomes more acute at the lower bound on nominal rates).
To date, the BoC has not signalled a policy pivot, unlike the Fed in December, and QT continues. A possible signal that requires careful monitoring, is the QT programme, even if the BoC has made clear policy rates are the main policy tool.
...an interim policy change could be to halt QT, and possible money market strains?
Interestingly, the Canadian Repo Rate Average (CORRA), the rate at which banks lend funds to each other overnight, has risen above the BoC's 5% target in recent months. This prompted the BoC into injecting liquidity through its overnight repo (OR) operations in January, operations...
conducted when the overnight collateralized interest rate is trading materially above the target policy rate and when broad overnight general collateral funding conditions warrant a temporary liquidity injection
Bank of Canada
However, the BoC moved quickly to clarify that such operations...
do not indicate a change in the stance of monetary policy, or in the normalization of the Bank’s balance sheet via quantitative tightening
Bank of Canada
Well-anchored inflation expectations are also supportive of policy easing?
Finally, the BoC’s policy mandate, renewed in December 2021, also references “well-anchored inflation expectations” as critical in the achievement of 2% inflation and maximum sustainable employment, and longer-term inflation breakevens have fallen in recent months.
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