Bank of Canada set for 25 bps rate hike, Scotiabank says

Markets are pricing in roughly 18 bps of tightening, making a rate increase next week the expected outcome, though not a certainty. That leaves scope for the Canadian dollar and short-term bond yields to react to the decision and accompanying language. Canada's two-year notes have posted the weakest performance among major-market front ends, mirroring the pricing shift. Oil plays a key role: Scotiabank highlights the possibility of an Iran conflict escalation after the U.S. midterms, which could drive energy and commodity costs higher, adding to Canadian inflation pressures. Higher oil prices typically boost the loonie, but they also reinforce the argument for more rate increases. Should the Bank of Canada refrain from raising rates, the Canadian dollar would probably fall, and markets might interpret the hold as a sign that officials are willing to accept inflation near the upper end of the target.

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The September inflation data provided the Bank of Canada with a milder top-line number, but Scotiabank contends that the end of summer travel does not justify keeping rates unchanged when forward-looking risks continue to accumulate.

Summary:

• Scotiabank forecasts that the Bank of Canada will increase its policy rate by 25 bps at the October 28 meeting.
• After the September CPI release, markets continued to price around 18 bps of tightening, matching the level seen following Governor Tiff Macklem's comments over the weekend.
• September's year-over-year headline CPI came in at 3.1%, slightly below forecasts and at the upper boundary of the central bank's 1% to 3% target.
• Core inflation measures softened in September, but the bank attributes the decline mainly to a steep drop in travel prices, with smoothed trends staying elevated.
• Scotiabank views a rate increase as protection against upside inflation risks, such as a potential Iran war escalation, rising commodity costs, and fiscal expansion.
• Surveys of businesses and consumers, as well as an Alberta election, are still scheduled before the decision.

A quarter-point rate increase by the Bank of Canada at next Wednesday's meeting is predicted by Scotiabank, which argues that core inflation is still sufficiently elevated to warrant a precautionary hike despite the September report being weaker than anticipated.

September's consumer prices increased 3.1% year-over-year, compared with 3.0% in August and a shade below expectations. That puts headline inflation at the upper limit of the Bank of Canada's 1% to 3% target. Although core measures declined during the month, Scotiabank noted that revisions upward to prior data and the smoothed trend indicate ongoing pressure; the bank's preferred three-month averages of the central bank's core gauges are approximately 2.6% to 2.7% annualised.

Scotiabank attributed September's weakness largely to a steep decline in travel prices following the end of the summer holidays. Travel services prices dropped about 25% on an annualised basis, and car rental prices fell nearly 40%, a decrease far exceeding typical seasonal patterns. Scotiabank said these movements call for caution regarding data reliability and argued that a drop in travel expenditure is not enough to hold rates steady. Excluding travel, core inflation would have been stronger and more widespread, with nearly 60% of the CPI basket seeing annual increases of 2% or more.

Scotiabank also noted a change in tone from Governor Tiff Maclem, who it believes has shifted focus to forward-looking inflation risks instead of historical data. At its last meeting, the central bank removed its characterization of the policy rate as appropriate, which Scotiabank interprets as a caution. The bank stated that policy is at the bottom end of neutral and negative in real terms, and that the central bank's staff have historically been prone to underestimating inflation at inflection points.

Markets seem to agree. After the CPI data, pricing for next week's decision remained at roughly 18 bps of tightening, and Canadian two-year bonds continue to be the worst-performing front end in major markets. Scotiabank said that since a rate increase is mostly priced in, not delivering would ease financial conditions in a manner that would be difficult to defend.

Looking at the longer term, Scotiabank highlighted the danger of an Iran conflict intensifying after the U.S. midterm elections, along with higher energy and commodity costs and another expansionary federal budget. It argued that monetary policy must counteract some of these pressures as economic slack diminishes. Surveys of businesses and consumers from the Bank of Canada, as well as an Alberta election, are still pending before the decision.