For much of the previous two years, the Bank of Canada and Federal Open Market Committee faced a relatively simple rate pathway: as inflation steadily cooled from the post-pandemic spike, both central banks had straightforward directives to gradually unwind their aggressive hiking series from decade-high levels, with the expectation that rates would ultimately return near the vicinity of low pre-COVID norms. Yet the breakout of the Iran conflict and the resultant surge in global energy prices has completely sapped – and now threatens to reverse – the prospects of an economic “soft landing” that had previously seemed attainable.

After the FOMC’s 25bps rate hike at its September meeting, focus now turns to the BoC’s upcoming decision this Wednesday. As of the time of writing, interest rate markets are pricing probabilities of a 25bps hike at roughly 85%. While such an outcome would certainly not be unreasonable given the current geopolitical and macroeconomic environment, it perhaps over exaggerates the BoC’s hawkish stance. There has been neither meaningful evidence of inflation spillover into core goods buckets, nor indications that consumer and employment health can remain stalwart amidst current economic uncertainty, to fully justify a rate increase in October – especially considering that the BoC still has optionality at an early December meeting should October data prove more inflationary. As such, there is significant asymmetric potential in the thesis that the BoC will instead elect to leave rates unchanged on October 28, remaining in “wait-and-see” mode with respect to October CPI and employment data, and deferring action to its next meeting on December 9.

Hike Sentiments Driven by Messaging, Not Data

The current market-implied hike probability of 85% reflects a sharp reversal from sentiments a week ago – odds were only 36% to end the Friday of October 16. Driving the tectonic shift was Governor Tiff Macklem’s hawkish-toned comments at the International Monetary Fund’s Bangkok meeting over the subsequent weekend, in which he expressed heightened concern over inflationary pressures and pointedto the fading effectiveness of releasing energy reserves as a containment measure. By Monday’s open, expectations had flipped with hike odds shooting up to 72% before ending the day yet higher at 82%.

That the dominant catalyst behind current market beliefs takes the form of a messaging interpretation rather than digestion of a data release suggests a disconnect between expectations and real conditions. Moreover, the data releases in themselves provide virtually no indication that an October hike is necessary. September CPI – headline and core – came below expectations at 3.1% and 1.8% Y/Y respectively, with the latter decelerating from August, nullifying the spillover hypothesis which has become the most frequently-cited reason that would necessitate a hike. On the labour front, a monthly loss of over 68,000 jobs that lifted unemployment to 6.5% similarly does not offer any rationale behind tightening monetary policy. When taken in isolation of the tone of Macklem’s communications, the combination of subdued core inflation and two consecutive months of jobs shed would point almost overwhelmingly towards a BoC hold. With this in mind, today’s extent of market expectations for a hike appears ignorant of Canada’s economic reality and effectively places the central bank’s next decision entirely on the premise of a pre-emptive action rather than a data-driven response. Such a stance could be easier to process in a case where September’s CPI release was a touch hotter or payroll data appeared slightly more solid, but the absence of either condition erodes the justification of a rate hike at this time.

Giving deeper thought to the current balance between inflationary risks and productivity preservation, any BoC decision should embody an automatic tilt towards the latter amidst the current geopolitical and macro backdrop. Choppy labour metrics, slowed GDP growth, weak consumer sentiment, and a lacklustre housing market (in which long-tenor mortgage offers, like the common U.S. 30-year, are nonexistent) all clearly paint an economy that carries natural insurance against demand-side inflation. The compounding effects of trade disputes against the U.S. add further slack that both explains the lack of core inflation spillover thus far and reinforces the low likelihood of it going forward. Very simply, the calculus implies far more deterioration risks than inflationary ones, and in a neutrally offsetting data scenario between the two, the prudent move is for the BoC to lean more dovish.

“Locking-In” Too Early

Recent history has set a precedent for the BoC acting against prevailing market expectations in October 2022 and June 2023 – one dovish (although in the context of a 50bps hike vs. expectations of 75bps), one hawkish. Tradition would also depict the BoC as a more “foot-on-the-gas” central bank than its U.S. counterpart, rarely relenting on hiking or cutting sprees once initiated. This brings significant timing considerations into play: a hike in October all but certainly locks in a subsequent follow-on in December and even January, amplifying the risks of miscalculation at a time when clear-cut data is unavailable. Given this dynamic, it could prove far more constructive to await October data definitively indicating the existence or absence of core inflation passthrough and revealing the true strength of the labour market, as opposed to locking the market into a hawkish trajectory in anticipation of a core spillover that may never come. The BoC holds ample flexibility in its hands that is unrecoverable if squandered – simply put, the cost of hiking one month too early far outweighs that of hiking one month too late. If core inflation does indeed pick up in November’s data release, the moderating effect would likely be similar whether the first hike is delivered pre-emptively in October or reactionarily in December. However, if economic slack continues to gate out its onset, a misguided pre-emptive hike risks generating significant burdens on consumers and businesses as well as broader market turbulence.

To be clear, the skepticism over the necessity of an October hike is not an expression against hawkism, but rather against pre-emptive hawkism in light of an abundance of optionality to act in a more informed fashion. The BoC faces no real urgency between now and December to make its definitive judgement call on inflation, thus the true odds for a hike should be a toss-up at best. From a macroeconomic perspective, there is far more sense in deferring the inflationary judgement call to December 9 and not only allowing the decision to be rooted in more certainty with respect to core inflation spillover and labour market health, but also giving a chance for more clarity on U.S.-Iran negotiations, U.S. midterms, and the ever-present flux of trade relations. It is my view, then, that current market expectations of a near-certain BoC hike on Wednesday are – in blunt terms – exorbitant. It is worth noting that Canadian institutional economists have also largely taken the hawkish side (with the exception of TD), albeit all admitting that conviction levels are relatively low. While an imminent hike could certainly be in the books, the arrival at one (or not) is a much closer race than currently suggested.