Last week, the Bank of Canada and the US Federal Reserve each cut their policy rate targets by 25 basis points. Below, we outline the rationale for these rate cuts and assess the likelihood of further easing, particularly as both countries face potential fiscal disruptions – a pending federal budget in Canada and the risk of a government shutdown in the US.
The Bank of Canada
The Bank of Canada cut its key overnight lending rate by 25 basis points on Sept. 17, bringing it to 2.5 per cent. This was the first cut in six months and in line with widespread expectations. The Bank cited three key developments in the economic landscape as reasons for its decision:
- Softening in the labour market. Since the July meeting, the Canadian economy has shed 106,000 jobs. The unemployment rate has crept higher and wage growth has eased.
- Removal of most retaliatory tariffs. The government’s decision earlier this month to lift most retaliatory tariffs is expected to impact upcoming CPI results, potentially lowering headline inflation measures by 0.1 to 0.2 percentage points.
- Easing of pressure on underlying inflation. This was the most significant factor. The three-month annualized trend in median CPI has declined from 3.4 per cent to 2.6 per cent since the July meeting, while CPI-trim has fallen from 3.2 per cent to 2.4 per cent.
The global backdrop has also weakened, with slower growth in both Europe and China. Canada’s Q2 GDP came in as expected.
With policy uncertainty still high, the Bank said it intends to “look over a shorter horizon than usual.” Policy will continue to evolve based on incoming data, with an emphasis on proceeding “carefully.” Notably, there was no mention of the potential for further easing, suggesting that a follow-up cut in October is not currently part of the Bank’s outlook.
The Bank has left the door open to a more tactical approach, with a shorter-term focus guiding its policy horizon. The most likely timing for any further rate cuts appears to be in December and March. One cautionary flag is the upcoming federal budget in November. Larger or larger-than-expected debts and deficits could push-longer term interest rates higher, which means fixed mortgage rates are unlikely to move lower in the near term.
While this is not likely to influence the Bank’s policy decision, it could affect how much lower short-term rates filter through to longer-term rates.
The US Federal Reserve
As expected, the Federal Open Market Committee (FOMC) cut policy rates by 25 basis points, setting the federal funds target range at 4.00 to 4.25 per cent. The Fed had been waiting to see how the administration’s economic policies – particularly tariffs – played out. With a solid labor market until recently, it had been afforded time and flexibility to assess the economic impact of those policies. However, with a significant weakening in labour data, the Fed’s dual mandate – inflation and employment – prompted a shift in its policy stance.
What’s interesting is that the decision was characterized as a “risk management cut.” This suggests the Feds wants to hedge its bets in case the economy slows down significantly.
The accompanying press release stated that “job gains have slowed, and the unemployment rate has edged up” while also noting that “inflation has moved up and remains somewhat elevated.” The Committee now “judges that downside risks to employment have risen” and are no longer balanced.
Interestingly, the Fed dot plot – which shows how each FOMC member expects rates to trend – diverged notably from market expectations. Most FOMC members expect two more rate cuts in 2025, one more than expected by the market. However, the dot plot now projects only one rate cut in 2026, with the federal funds rate ending the year around 3.4 per cent. The market had been expecting rates to fall below 3 per cent by the end of 2026.
While the market got the rate cut it was looking for, there could be turbulence ahead from the fiscal side in the coming weeks.
The fiscal year 2025 ends on Sept. 30, and so far, Congress has not enacted any of the 12 full-year appropriation bills needed to fund the government for fiscal year 2026. Lawmakers have until midnight on Sept. 30 to avoid a lapse in government funding; otherwise, a government shutdown will occur.
Shutdowns are typically short-lived – a few days to a couple of weeks. With the recent $5- trillion debt limit agreement, there is little concern about managing the debt. How long a shutdown lasts will largely depend on the politics of who is blamed for the impasse.
Most likely, markets will treat this as temporary noise over the next couple of weeks. I don’t expect it to sideline any policy decisions by the Fed.
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