Faster move to neutral rate could help Bank of Canada fend off below-target inflation

By Fergal Smith

TORONTO (Reuters) - The Bank of Canada is likely to lower interest rates to a neutral setting that neither restricts nor stimulates its economy more quickly than the U.S. Federal Reserve, say analysts, who see weak Canadian growth raising the risk of a sustained drop in inflation below the central bank's 2% target.

The BoC estimates the neutral interest rate - where its policy rate settles when the economy is in equilibrium - to be in a range of 2.25% to 3.25%, with a mid-point of 2.75%. The estimate among Fed officials is similar, at 2.9%, with a central tendency estimate among policymakers in the 2.5%-to-3.5% range.

A faster move to the neutral rate could offer relief to heavily indebted Canadians. It could also weigh on the Canadian dollar, which touched a two-month low on Thursday at 1.3775 per U.S. dollar, or 72.60 U.S. cents.

"The BoC has more reason (than the Fed) to be in a hurry to reach its neutral rate, as slower growth in Canada implies more slack in the economy," said Andrew Kelvin, head of Canadian and global rates strategy at TD Securities.

That anticipated divergence in the BoC's and Fed's paths toward a neutral rate comes as they and other central banks are now aligned in cutting interest rates. But in contrast to their unified race to raise rates when inflation was a global threat, top central banks now differ in how long and how far to take easing cycles to keep inflation in check and their economies growing.

Investors are betting it will take less than one year for the BoC to reduce its benchmark interest rate to 2.75% from its current 4.25% but doubt the U.S. economy will weaken sufficiently for the Fed to lower borrowing costs to the neutral setting in the current easing cycle.

Canada's economy has grown in recent quarters more slowly than the roughly 2.4% pace the BoC sees as its potential. That has helped cool inflation, which hit 2% in August, but the central bank says additional economic slack would be unwelcome.

The Canadian employment report for September, due on Friday, could offer further clues on the state of the economy. It is expected to show the unemployment rate rising to 6.7%, which would be an increase of 1.9 percentage points since April 2023.

INSURANCE POLICY

The BoC is due to make an interest-rate decision and update its economic projections on Oct. 23. It has stuck with quarter-percentage-point moves in its first three rate cuts but analysts say the Fed's decision to begin easing in September with an unusually large half-percentage-point cut raises prospects of the BoC moving in larger steps.

"We expect the Bank of Canada will cut rates by 50 basis points this month, with the domestic economy underperforming and significant challenges on the horizon," said Royce Mendes, managing director and head of macro strategy at Desjardins.

"Population growth is set to dramatically slow and the worst of the mortgage-renewal wall has yet to be felt."

Many Canadians are likely to renew their mortgages in the coming years at much higher interest rates after borrowing heavily and at rock-bottom levels in 2020 and 2021.

"Moving faster towards the neutral-rate range would be an insurance policy against inflation sustainably falling below target," Mendes said.

The potential for below-target inflation has not been lost on investors, with breakeven rates, the market's measure of expected inflation, falling further below 2% in recent months.

"If Canada begins to miss its inflation target to the downside, that is a scenario that would lead to significant currency depreciation because the Bank of Canada would have the green light to cut rates at a time when the U.S. isn't feeling that pressure," said Adam Button, chief currency analyst at ForexLive.

(Reporting by Fergal Smith; Editing by Rod Nickel)