Avery Shenfeld, CIBC’s Chief Economist joins Andrew Grantham, Executive Director & Senior Economist, to discuss Canadian inflation, central bank policy and the Canadian dollar.
Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets. A podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.
Andrew Grantham: Welcome to the latest edition of Eyes on the Economy podcast. I'm Andrew Grantham, Executive Director and Senior Economist at CIBC. And today we are recording this podcast on May 21st, just hours after the latest inflation numbers. Today I'm joined by Avery Shenfeld, our Chief Economist to go through some of those details. Avery, welcome.
Avery Shenfeld: Nice to be here.
Andrew Grantham: Excellent. So we're going to talk a little bit about inflation today. We've just received some latest inflation numbers for April. But before we get into the details of those, food price inflation over the last couple of years has been a key issue for everybody who has to buy food, go to the grocery stores. It's been driving a lot of the inflation that we've been seeing. It's now starting to ease off. But you made a point last week that food price inflation isn't just impacting overall CPI, overall inflation, it is also impacting some of the core measures that the Bank of Canada looks at when it judges policy. Can you just explain to us how it does that?
Avery Shenfeld: Well, they say that you are what you eat in terms of inflation in your own waistline, that's true, but also in terms of overall price inflation in Canada. It ends up being that food inflation is quite important, which is a surprise to some because of course around the world, a lot of countries use inflation excluding food and energy as their benchmark of inflation. That's not the case here in Canada. We have a couple of official measures, trim and median inflation. And it turns out that the food basket is particularly important in driving that. So of course, food is a significantly weighted item. So it would of course be correlated with overall inflation measures and those core measures. But importantly, the food basket actually has a better correlation with the core measures of inflation than it does with overall inflation. And it's the only one of the major categories that has that. I think it's because of the fact that food is a very diverse item. So you've got both goods in the sense of the food you buy for home consumption, but also services because it includes restaurant or food away from home. You've got a mixture of many inputs, including transportation costs and labor and store rent and so on. So the very diversity of the food basket for both goods and services means that it captures a lot of the trend in inflation. And it of course is a necessity. So it has to somewhat line up with household purchasing power in a way that some other items that are less necessary don't necessarily have to do so. So food actually is often used as a benchmark of purchasing power. You've heard of the Big Mac index to look at how much you can buy around the world. And food inflation is very important then in core inflation in Canada. And so we, on Friday, wrote that there was some chance here that, in fact, food would help play a role in further slowing core inflation in Canada because we had been getting some tamer readings, and to some extent, trend is your friend, but also we'd had a preview of Canadian inflation with the food inflation numbers from the US that were particularly tame in April, and that came through in spades in today's CPI numbers for Canada.
Andrew Grantham: Yeah, and those April numbers, it wasn't just food prices actually that were kind of slimming the waistline of inflation this time around. You know, we have seen even some of the exclusionary measures excluding food and energy. You know, it all seemed pretty tame to me when I looked at these numbers. So what did you think when you saw this latest report and what do you think that means for the Bank of Canada as they go towards that June decision?
Avery Shenfeld: There's so many different ways you can slice and dice the inflation numbers, but in this case, virtually every way you did that gave us the same message that really for the past four months and to some extent really for the past year, inflation has become a lot less problematic in Canada. And remember, we've been benefiting from the same sort of easing in global supply restraints that have helped the US. But in addition to that, have had a significant slowing in the Canadian economy, a slowing that has slowed household income and spending power and is translating into soft inflation number. And to me, the number that stood out most among all those variations on that theme was that if you look at the CPI excluding mortgage interest, so just take out mortgage interest, which of course has risen because of the Bank of Canada's rate hikes, that measure is running at 1.6 % over the past year. So essentially, if it were not for higher mortgage rates, Canada's inflation rate would actually be below the Bank of Canada's 2% target. And I think since that's really the last barrier to get inflation down, the Bank of Canada really does have to proceed with a rate cut in June. There's really no excuses left and likely follow that up in July. And they don't have to make any pledge beyond that. And I think they're going to keep their cards close to their vest in terms of signaling how far they're going to go. But starting the ball rolling makes perfect sense.
Andrew Grantham: Yeah, so after these inflation numbers, I think it's safe to say we're feeling a little bit better about this forecast for the June to be the first cut for the Bank of Canada. Now, we still have a wait until September, possibly even later for the Federal Reserve to start cutting interest rates. So, you know, the fact that the Bank of Canada is very likely to be moving ahead of the Federal Reserve, you know, what do you think that means in terms of the currency. It only seems to be partly priced into financial markets at the moment, this divergence?
Avery Shenfeld: That's true, although you can see that the Canadian dollar wallet weakened a bit today. It's hardly a runaway freight train against the loonie. And I don't think at this point it's going to surprise a whole lot of people that the Bank of Canada moves first. So why isn't the Canadian dollar weakening a lot more? Well, for one, you know, if you look out over a couple of years, I think the market does expect that even if the Bank of Canada moves first, the Fed will certainly join in the party of cutting interest rates at some point over the next year and that the gap between Canadian and U.S. rates is not going to get that wide if we think about where that gap will be a year or two from now. Our estimate is that Canadian neutral rates are about 50 basis points below the U.S. neutral rate. So if both central banks eventually end up taking the overnight rate to a neutral position, that would only be a 50 basis point spread between the two countries. It's not really enough to send the Canadian dollar into a freefall. But the other thing is that observers often overstate the role of the Canada -U.S. interest rate differential, or indeed anything about Canada, in terms of thinking about the Canadian dollar exchange rate against the U.S. greenback. Turns out that if you look, for example, over the past two decades, the monthly level of the Canadian dollar against the US dollar and the monthly level of the European euro against the US dollar have an 85% correlation over that period. In other words, periods in which the US dollar is gaining on the euro tend to be periods where the US dollar is also gaining on the Canadian dollar. But if we enter a period, for example, where the US dollar gives up some of its gains that it's had immense major global currencies like the Euro, the Canadian dollar will also tend to strengthen against the US dollar. And that's why our forecast is that although we do see Dollar Canada getting up to 139 over the next few months as the Bank of Canada does a couple of cuts before the Fed has moved at all, I don't think we go beyond that and we're likely to recover. The US dollar has had a long run against other major currencies. It benefits from a flight to safety bid during uncertain times. And if the global economy is in a healing mode, particularly as we get into 2025, we would expect the US dollar to give back some of those gains. You often see that sort of mean reversion trend after a while. And the US dollar is very heavily valued now. If you look at trade fundamentals, the US isn't doing very well in terms of trade balances. I think that signals that the US dollar is a vulnerable currency. And we do expect, therefore, the US dollar to generally being on a weakened trend, particularly into 2025, which should help the Canadian dollar recover whatever it might lose in the next few months on a more aggressive and earlier rate-cutting stance by the Bank of Canada.
Andrew Grantham: So if this isn't necessarily a domestic story of Canadian dollar strength or weakness, if it's been driven by broader moves in the US dollar, I agree that there's good reasons to see the US dollar depreciate a little bit for the reasons that you cited. But what would be the risk? What would drive a sustainably stronger US dollar, which would then impact our currency going forwards?
Avery Shenfeld: Well, oddly enough, those who are worried about the Canadian dollar depreciating more than our forecast and staying weak should be paying a close eye to European fiscal policy. It might surprise you that that seems pretty far flung, but it could be a big driver of the US dollar against the euro, the other key major currency. The reason for that is that Europe has again reimposed fiscal rules that it abandoned when the pandemic hit and the war in Ukraine broke out. And under those fiscal rules, European countries, members of the EU commit themselves to a path that will take them to a deficit of no higher than 3% of GDP and a debt no higher than 60% of GDP. Now, those rules tend to be somewhat loosely enforced. There's not a lot of enforcement teeth behind them, but nevertheless, the fact that the countries have negotiated this, have agreed to it, does suggest that we will see at least some tightening in European fiscal policy over the next couple of years. Now we're expecting a lot of cheating in this and not really that much of a belt tightening exercise, but if Europe does really get religion over fiscal policy and tighten fiscal policy more than we're counting on, that's going to be a significant drag on growth in the Eurozone and might require then the ECB to be more aggressive in cutting rates than we're now factoring in. The converse of that is we don't know the results of the next election in the US in November, either the presidency or the members of Congress and the Senate, but that could clearly have an impact on American fiscal policy. So we're not expecting to see any real tightening in US fiscal policy. But if, for example, the US were to loosen fiscal policy aggressively, pass another big tax cut, for example, without any real restraint on spending, then that could stand in the way of cutting rates by the Fed as much as we're pricing in. It could provide some offsetting stimulus. So if we really see a big diversion between belt tightening fiscally in Europe and an easing in fiscal policy in the US, you could get a wider diversion in interest rates between the US and Europe that could sustain US dollar strength. And that's really the scenario that those who are worried about the Canadian dollar weakening have to pay attention to because of that very strong correlation between where the US dollar goes against the euro and other major currencies and how it plays out against the Canadian dollar. But domestically, we don't think that this more aggressive Bank of Canada, at least in 2025, is really going to spark any sustained run against the Canadian dollar on its own.
Andrew Grantham: Excellent. Thanks for that. From Canadian food price inflation to European fiscal policy, I think that wraps it up for this edition of Eyes on the Economy podcast. Avery, thank you very much for joining me today. To everyone listening, have a great rest of the week.
Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.
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