By Douglas Porter

May 24, 2024

With the Fed stuck in neutral for a spell, how far can other global central banks carve out an independent path? That key question of recent months re-emerged in a significant way this week, as potential Fed rate cuts were pushed further into the future. First, the few U.S. economic data releases mostly surprised on the high side, after a run of downside results earlier this month. Notably, durable orders were solid through the spring, and S&P’s PMIs reported gains across the board in May. Second, the latest FOMC Minutes revealed that “various” members had actively considered whether rates eventually needed to go higher at the latest Fed meeting. Chair Powell has already suggested rate hikes are unlikely, and the recent moderate CPI probably soothed the concerns of others, but let’s just conclude that the “various” few are not going to be voting for rate cuts anytime soon. Markets now only have a full rate cut priced in by the December meeting, and more analysts are spying a no-cut year.

This shifting reality on the Fed finally made a minor mark on equities this week. Most major averages took a step back after hitting fresh record highs within the past five sessions, even with the support of yet another blow-out quarter by Nvidia. The Dow, which is not blessed with the presence of the AI/chip darling, saw its biggest setback in more than a year on Thursday, less than a week after reaching the promised land of 40k. The setback leaves the Dow up a pedestrian 4% so far this year—and we are now almost 40% of the way through 2024, for those counting—compared with an 11% gain for the S&P 500. Unsurprisingly, Treasuries were also not enthused by the combination of firm data and rate hike chatter, with 10s rising back to around 4.5% and 2s rising more than 10 bps to back above 4.9%. The dollar was the one winner, nudging up after a month-long retreat, leaving a trade-weighted basket up 4% in 2024.

But does an on-hold Fed limit or even handcuff others, particularly the Bank of Canada? The chances of the Bank trimming rates at its upcoming meeting on June 5 actually rose this week, on yet another mild Canadian CPI result and more softness in retail sales. On the latter, sales fell for the third month in a row in March, and are now up a paltry 1.9% from a year ago, or just 0.8% in real terms, and deeply negative on a per capita basis. Sluggish spending is clearly cooling underlying inflation. All the major measures of core CPI rose just 0.1% m/m in April (seasonally adjusted), holding the annualized increases below the 2% target since the start of the year.

The contrast between Canadian and U.S. inflation trends in 2024 could not be starker. To pick but one glaring example, markets cheered last week’s U.S. April CPI, where core still rose 0.3%, and we are expecting a mild 0.2% rise in next week’s core PCE deflator. Good news, but this is still above the latest 0.1% result in Canada. And consider the four prints on U.S. core CPI so far this year—0.4%, 0.4%, 0.4%, 0.3%, or up at an annualized rate of 4.3%. The PCE deflator is up 0.5%, 0.3%, 0.3% and an expected 0.2%, for an annualized rise of about 4.0%. In contrast, the average of the two BoC core CPI measures has been 0.1%, 0.1%, 0.1%, 0.1%, or up at an annualized 1.4%. And after starting the year with Canada and the U.S. running at precisely the same headline inflation rate of 3.4%, the U.S. has seen no change while Canada’s rate has dropped to a much more comfortable 2.7%. Excluding those bothersome shelter components, Canadian inflation is now a minuscule 1.2%.

What is driving the growing gap in North American inflation? Fundamentally, one can pin it on the much weaker growth and spending trends north of the border, as well as a tighter job market stateside. Food and energy costs have not played a role, as the soft Canadian dollar and the carbon tax have nudged up relative energy costs (up 4.5% y/y in Canada vs a 2.6% rise in the U.S.), while food prices are tracking very closely (at up 2.3% and 2.2%, respectively). Excluding food and energy, the inflation gap grows to 0.9%, with U.S. core at 3.6% and Canada at 2.7%. But that wide spread is not due to core goods prices—those are down 1.3% y/y in the U.S. amid a deep dive in vehicle and furniture prices, while up a tad in Canada. And the gap definitely can’t be explained by shelter costs, which are actually running hotter in Canada (up 7.1% y/y vs 5.5% in the U.S.).

That leaves only services prices outside of housing as the culprit for much stickier U.S. inflation compared to Canada. Some of the largest gaps there include telephone services, auto insurance, child care costs, vehicle maintenance, and hotel charges. Picking one from the list, auto insurance costs have risen a meaty 6.8% y/y in Canada, which puts it at a top-five inflation driver, but they have exploded 22.6% y/y stateside. Weighing in at nearly 3% of the CPI basket, this one component has accounted for nearly 0.7 ppts of overall U.S. inflation all by itself. It, and many of the other items on the list, are likely not very sensitive to monetary policy, but the Fed must stay vigilant on all forms of inflation, whatever the source, with an eye on expectations. And the latest University of Michigan survey finds that said expectations are pretty much locked in at 3% or higher over the next one to five years.

Inflation expectations and perceptions have scarcely been squashed in Canada either, but the economic case for rate cuts is still solid. After a small burst at the start of the year, it looks like GDP growth cooled considerably in the spring, with next Friday’s result likely to reveal a drop in March (even with a 2% rise in Q1 as a whole). Full year real GDP growth will barely top 1%, despite 3% population growth. The jobless rate has climbed a full percentage point in the past year, even with some gaudy employment gains. The housing market has been (eerily) calm in the prime spring season. And all measures of core inflation are now below 3%, and apparently headed lower with short-term trends all below 2%. Even the Canadian dollar has been mostly quiet for the past month at just under $1.37/US (or just above 73 cents), even as the market has priced in one additional BoC cut than for the Fed.

Bottom Line: Central banks will do what needs to be done for their domestic economies. But with the Fed standing pat for a long stretch, the Canadian dollar will come under some renewed downward pressure if it appears the Bank will diverge by more than one easing step from the Fed. Any such currency move would reinforce an easier policy stance, which likely means that the BoC will need to do less on the rate front than would otherwise be the case. So, yes, the potential for a lighter loonie will indeed limit the degree to which the Bank will ease. We continue to pencil in cuts in the June, September and December meetings (i.e., every other decision), based on the assumption that there will be a line of sight to Fed rate cuts at some point in the second half of the year.

Douglas Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.