The Bank of Canada cut the benchmark interest rate by a quarter point to 4.75 per cent, signalling an end to one of the most aggressive inflation fights in the central bank’s history. Governor Tiff Macklem said more cuts are coming, but hedged on when they might happen. Here’s what you need to know. 

The rationale: At 2.7 per cent, year-over-year changes in the consumer price index—the gauge that sits atop all others on governor Tiff Macklem’s dashboard—are still on the high side. But the central bank said it was confident that “underlying” measures of price pressure suggest inflation is on its way back to the target of two per cent. 

Specifically, Macklem flagged the Bank of Canada’s preferred measures of core inflation, three-month rates that show price pressures are receding fast, and the number of items in Statistics Canada’s price basket that are increasing faster than three per cent is back at its historical average. 

“We’ve come a long way in the fight against inflation,” Macklem said in remarks prepared for a Wednesday press conference in Ottawa. “Our confidence that inflation will continue to move closer to the two per cent target has increased over recent months.”  

Weak rebound: The Bank of Canada noted the economy has recovered after stalling in the second half of 2023. But the motor isn’t revving like it should. Growth was weaker in the first quarter than the central bank forecast and the population is increasing faster than employers are creating jobs. The central bank described consumption as “solid,” but it’s unlikely highly indebted households will power the economy the way they have in the past, amid higher interest rates. A first-quarter increase in business investment might have been premised on expectations of lower borrowing costs. Macklem reminded reporters that output is running below the central bank’s estimate of the economy’s capacity to generate inflation-free growth, suggesting companies will have little trouble keeping up with stronger demand. 

“There’s room for the economy to grow,” Macklem said at the press conference. 

Curb your enthusiasm: Macklem has warned audiences on numerous occasions this year that it would be a mistake to assume interest rates will go back to their pre-pandemic, near-zero setting. This week he cautioned against assuming policymakers will opt to cut rates again when they next meet in July. The economy is struggling, but it’s not in a recession. As the Fed discovered in the U.S., inflation can get sticky. Macklem observed that geopolitical tensions, housing prices and unusually strong wage growth all could stoke inflation. 

“If inflation continues to ease, and our confidence that inflation is headed sustainably to the two per cent target continues to increase, it is reasonable to expect further cuts to our policy interest rate,” Macklem said. “But we are taking our interest rate decisions one meeting at a time. 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.”  

Powell’s shadow: At the start of the year, most assumed Federal Reserve chair Jerome Powell would clear a path for Macklem to cut rates. Macklem might have preferred that, as a gap between interest rates in the two countries invites distortions, especially around exchange rates. But the U.S. economy remained too strong, and some now wonder if the Fed is stuck. 

The limits Fed policy has imposed on the Bank of Canada are less restrictive than many assume. Canadian borrowing costs tend to mirror U.S. rates because the two economies are so intertwined—if the U.S. economy is heating up, then Canada’s economy will be too (and vice versa). But the two countries aren’t exactly the same. Canada’s economy is more geared to commodity prices, while the U.S. is prone to occasional financial crises. Canada’s benchmark rate was about a half point lower than the equivalent U.S. rate in 2019, and a full percentage point lower in 2007, according to calculations by Desjardins.  

Economists at Desjardins and CIBC reviewed research on the extent to which a weaker exchange rate stokes inflation by making imports more expensive, and found that it would take a big gap to open before that became an issue. The bigger inflationary threat is from the exchange rate’s influence on exports. A weaker dollar is good for trade, and trade is good for demand. Given how Canadian economic growth has begun to flag, a jolt from exports likely won’t cause much inflation.

“We don’t need to move in lock and step with the Federal Reserve,” Macklem said at the press conference. 

The reaction: The Canadian dollar fell against the U.S. currency, but only marginally as most traders had already priced a rate cut today. The yield on Canadian two-year notes was down around 10 basis points, according to Bloomberg. Bay Street economists were split on when the next rate cut will come. Toronto-Dominion Bank, which predicted the central bank would wait until July to cut, now predicts a “cut-pause-cut” path, with the next cut coming in September. Citibank, which also forecast a July cut, now forecasts a quarter point reduction at each of the four remaining policy meetings this year. 

Bottom line: Macklem began his term as governor four years ago this month and had never cut interest rates before today. The Bank of Canada estimates that the “neutral” rate of interest—a theoretical setting that would neither help or hurt the economy—is around three per cent, so there’s a gap between where we are now and something more normal. It would be aggressive to bet that the central bank is primed to cut rates at every meeting until it gets to three per cent. But if inflation continues to slow, another rate cut in July seems possible.