The Bank of Canada cut interest rates as it sees a soft landing on the horizon, making it the first Group of Seven central bank to kick off an easing cycle. 

Policymakers led by Governor Tiff Macklem lowered the benchmark overnight rate by 25 basis points to 4.75 per cent on Wednesday, as widely expected by markets and economists in a Bloomberg survey. Officials say they’re more confident that inflation is headed to the two per cent target, and said it’s “reasonable to expect further cuts,” if progress continues.

“With further and more sustained evidence underlying inflation is easing, monetary policy no longer needs to be as restrictive,” Macklem said in an opening statement.

Bonds rallied after the cut, and yields on the government of Canada 2-year note fell 10 basis points on the day as of 11:25 a.m. Ottawa time. The loonie depreciated to $1.3711 per U.S. dollar.

The bank indicated the easing path is dependent on continued inflation progress, which policymakers say is “likely to be uneven.” Officials flagged global tensions, a faster-than-expected rise in home prices and high wage growth relative to productivity as potential risks to the outlook.

“We don’t want monetary policy to be more restrictive than it needs to be to get inflation back to target. But if we lower our policy interest rate too quickly, we could jeopardize the progress we’ve made,” Macklem said.

The Bank of Canada’s first rate cut since 2020 shows officials are increasingly confident they’re getting closer to declaring victory over inflation, which has fallen to a yearly pace of 2.7 per cent after peaking in mid-2022. That allows policymakers to start normalizing interest rates after one of the most aggressive hiking cycles in the history of the central bank.

First-quarter gross domestic product growth at 1.7 per cent was weaker than the bank had forecast. But last year, the economy was quite weak, Macklem told reporters at a news conference following the decision. He added that consumption growth has strengthened in recent quarters.

“We’ll certainly be looking at our growth trajectory going forward,” Macklem said, adding that so far it is looking like a “soft landing.”

“The plane hasn’t been landed yet. We’re not cheering yet. The runway’s in sight, but we still need to land this.”

Still, there’s uncertainty as to how quickly borrowing costs will fall. Alongside risks to the inflation outlook, the Bank of Canada has moved before the U.S. Federal Reserve. Historically, the countries’ interest rates have tended to take a similar path, and when they don’t, there’s some pressure on the currency. A weak loonie means higher import costs, risking higher inflation.

Macklem told reporters Canadian monetary policy has diverged from the U.S. in the past. Conditions are different in the two countries, as inflation has eased more in Canada while the U.S. economy has been stronger.

“I don’t think we’re close to that limit,” he said. “There’s no sort of bright line, and you can see from history there have been periods of considerable divergence.”  

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The Bank of Canada’s decision to cut comes a day before the European Central Bank is widely expected to lower borrowing costs, making the northern nation the first in the G-7 to launch into an easing cycle. The Canadian central bank joined the Swiss National Bank and Sweden’s Riksbank to pivot to easier policy as inflation risks subsided.

Since the beginning of this year, inflation in Canada has decelerated faster than expected. The consumer price index slowed to 2.7 per cent in April versus the central bank’s forecast of 2.9 per cent for the second quarter. Underlying price pressures have also eased for four consecutive months, with an average of the two core measures reaching 2.75 per cent in April.

Overall, policymakers see the economy in excess supply, and wage pressures moderating gradually. Still, consumption remained resilient early this year and the economy showed strong momentum heading into April, when the labour market added the most jobs in more than a year. 

What Bloomberg Economics says...

“Easing inflation and excess production capacity prompted the BoC to cut rates. We also think expectations of weakening consumption growth as mortgage rates reset played into the decision. Still, lower rates run the risk of stalling disinflation — or even re-accelerating inflation.”

-Stuart Paul, U.S. and Canada economist 

“Rather than waiting for a recession to take hold, officials are acting pre-emptively to guide the economy toward a soft landing,” Royce Mendes, managing director at Desjardins Securities, said in a report to investors. “With challenges on the horizon and monetary policy only working with a lag, today’s 25 basis point rate reduction is consistent with a risk-management approach.”

The bank’s language suggests that as long as inflation continues to moderate and remains consistent with the target, further cuts are likely, Charles St-Arnaud, chief economist at Alberta Central, said in an email.

“While the language remains cautious, it does not dismiss the possibility that the BoC could cut again in July, subject to inflation.”

Interest rates are still high and will still be at levels the bank views as ‘restrictive’ by the end of this year even if an expected 100 basis points worth of cuts materialize, Claire Fan, economist at Royal Bank of Canada, said in a report to investors.

“Still, the move itself signifies confidence among policymakers that the most likely path for future inflation in Canada is down,” she said.

Between now and the July rate decision, there are two more reports for inflation as well as for jobs and retail, and the release of April gross domestic product data. Officials say they’ll continue to focus on demand and supply in the economy, inflation expectations, wage growth and corporate pricing behaviour.

Policymakers say they’ll continue quantitative tightening and normalize the balance sheet.