The Last Mile of Disinflation: The Fed Falls Behind

Inflation has come down, though it remains above target in most countries and other inflationary shocks aren’t out of the question. The odds of additional interest rate hikes are low, but rates could remain at their current level for longer if progress on inflation stalls. There’s also a great deal of uncertainty surrounding the lagged effect of higher interest rates on economic growth. As mortgages continue to be renewed at higher rates, many Canadian borrowers could feel the squeeze. Higher unemployment could also lead to challenges for the housing market. The US presidential election in November could be an inflection point that adds even more uncertainty. Fiscal deterioration in the United States and elsewhere could prompt credit ratings downgrades and possibly push longer-term interest rates higher. Worsening geopolitical tensions could also spell instability for the global economy, financial markets and commodity prices, particularly in the wake of the recent Israel–Iran confrontation, or if the war in Ukraine intensifies again. From a currency perspective, if the global economy encounters new headwinds, many investors may park their assets in US dollars, sending the greenback soaring. A further widening of interest rate differentials with the United States would have the same effect. Rapidly cheapening currencies would in turn have a destabilizing effect for many economies.

With inflation running persistently high in the United States, many investors now expect interest rate cuts to be more moderate in that country. We've scaled back our forecast to two cuts in 2024. The first should come around fall, provided that inflation eases and the country's economy cools a little. Strong productivity growth in the US should help bring down inflation. On our side of the border, the Bank of Canada may already have enough reason to start cutting interest rates as inflation abates. Canada and the US can take divergent monetary policy paths to a certain extent, but not without impacting the Canadian dollar. The loonie has already depreciated in the past few weeks, as have several other currencies. It will likely remain low for another few months and could even momentarily reach CAN$1.40/US$. Rising bond yields recently dampened the stock market rally, and while several valuations remain high, there's room for them to fall in the coming months.