Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Avery Shenfeld: Welcome everyone to this latest edition of CIBC Economics’ Eyes on the Economy podcast. I’m Avery Shenfeld, Chief Economist at CIBC, and I have the pleasure of being joined today by Helen Lao, an Executive Director and Senior Economist on our team. We’re here to discuss the latest developments in central banks, both on the US side of the border and in Canada in the most recent week, and what we’ve learned in the wake of those decisions by the central banks in terms of what may come next for monetary policy and the interest rate outlook on both sides of the border. So, Helen, let’s start with what the Fed opted to do. Their decision to pause didn’t really come as a surprise, at least not relative to expectations in the week or two before the meeting, because members of the Fed’s committee had pretty much telegraphed that they seemed intent on taking a pause. What was a surprise was when they said that because it seemed contrary to the data, which was really showing no improvement in the inflation picture, still heated core inflation, no real signs of slowing in growth. So what did we learn, if anything, from what the Fed then said or from Kevin Warsh’s press conferences, about what the committee’s reasoning was to pause now, and why it still seems on course to hike again soon.

Helen Lao: Yeah, so Warsh actually didn’t give a straightforward answer in the press conference to explain the decision to pause. He pointed to stricter financial conditions since the hike in September, but he also said that while they’re tighter, he wouldn’t call financial conditions as tight. And when the press asked him again on why they paused, he pointed to the same line in the statement about waiting for more information and reiterated that they don’t make decisions based on one single data point. And went on to talk about what he calls the monetary medicine that the Fed has put in, but also concluded to say that they have yet to achieve price stability. So I think the bottom line of that convoluted answer is that they think with the action put in place in September, they have built enough credibility that waiting six more weeks would cost them a little. And he calls the period ahead as information rich. Obviously, with midterms elections happening next week, there could be a lot of policy developments in the next couple of weeks. So maybe they just want to wait that out. But politics is not something that the Fed will say influence their decision. So that’s why I think you kind of get this kind of awkward answer from Warsh. A December hike is pretty much expected by the market going into this decision. The median dot plot still shows another hike by year end. And with two dissents in this pause decision and today’s PCE data confirming the lack of progress on inflation, I think they still need to act in order to address the inflation issue.

Avery Shenfeld: One of the things that people noted is that there were a couple of dissents in favor of a hike. That wasn’t quite as much as if we go back to the meeting where they paused and then hike, there had been three dissents. But it was a bit of an eyebrow raiser to see that Lisa Cook was one of the people who dissented in favor of a hike. I don’t think she was really thought of as a real hawk on the issue. She is still under investigation by the Trump administration. Do you see that then as a sign that she wanted to put up some resistance to basically what may have appeared to be a move to avoid a hike before the midterms, which was somewhat then politically motivated by what the president might have wanted to see.

Helen Lao: Yeah, so this was actually the first time she dissented since joining the Federal Reserve Board in 2022. And the first dissent really from a governor since Warsh’s tenure as chair so far. Whereas the other dissent, Beth Hammack from the Cleveland Fed, had already dissented once in July in favor of a hike. While I think there are plenty of good reasons to vote for a hike this time, it’s hard not to think about she may be motivated in part by these constant legal threats. The White House has doubled down on their effort to oust her. Her private hearing is next week. So the timing is also curious. But when asked about if politics were a factor in the monetary policy decision, Warsh said there was no mentioning of that in the meeting and who believed everyone voted the way they believed was the best policy action. So I guess we have to take his word for that.

Avery Shenfeld: You sound a bit skeptical there, but we’ll let that go.

Helen Lao: (laughs)

Avery Shenfeld: Let’s talk a little bit then about what CIBC’s view is on where the Fed will take interest rates from here. And relative to that point forecast, where do the risks lie? What could cause the Fed to hike more or less than our current forecast suggests?

Helen Lao: Yeah, so our forecast calls for another hike in December. The market now places the odds of a December hike at 80%. And I think if we don’t see a significant decline in oil prices in the next six weeks, there won’t be any really significant progress on inflation until the next meeting. and you know, with the conclusion of the midterms elections, I think they could hike again in December. But after December, which is almost completely priced in now, I think the Fed could wait and see a little bit, and that’s our call. and that’s because the main risk with higher rates is choking off the AI-driven economic growth. Economic growth is solid, as we see in this morning’s Q3 GDP report, but the concentration risk is real. That strength and growth in the economy right now relies heavily on AI investment and the spillover into stronger equity gains that’s fueling consumption. And I think there are two camps of thinkers out there when it comes to interest rate sensitivity of that AI investment. And that determines where you see the risk of higher rates. I think there’s one camp that thinks AI boom is too big and they’re very flush with cash and therefore not as interest rate sensitive as other sectors. But there are recently more people voicing concerns, including actually Warsh yesterday, saying that he’s worried that interest rates get in the cracks and interest rates affect directly and indirectly almost everything, including AI. And that’s looking increasingly likely as tech companies increasingly turn to bond and stock markets to finance growth they once paid for out of their own cash. So the risk again is high interest rates could choke off AI-driven growth. And we don’t know yet how much that threshold is for rates to go up before we see the cracks. So, Avery, let’s turn to talk about the Bank of Canada decision. You and other economists switched your call to a hike based on governor’s hawkish comments to the reporters while at the IMF meeting. And it turned out that was in fact a signal to markets to price in a hike that they otherwise wouldn’t expect. Was this hike a potential policy mistake? And how worried should we be about that?

Avery Shenfeld: Well, I do think it’s potentially a mistake, but I don’t think should we should be that worried about it. You know, what’s a quarter point between friends after all? The reality here is that this will have been the right decision if things go a certain way on both the Iran and oil price outlook and the Canada US trade outlook. So if the governor is right that there’s no end in sight for high energy prices, and if Canada does manage to hammer out some sort of deal to reduce tariffs, and there certainly are still some discussions going back and forth across the border on that topic, then hiking now as opposed to waiting a while will not have been a mistake because the economy will likely have some inflation and momentum, and the Bank of Canada would likely have wanted to take some steps to stand in the way of that. The way it could end up being a mistake if those geopolitical developments go the other way. And that’s why we favored waiting rather than making a decision now, simply to get that additional information, which we do think will largely be in hand either by December or January. So on the Iran front, remember that the president is talking about relaunching the war again in terms of an active assault on Iran. But also at the same time, there are diplomatic efforts to try to resolve this without a conflict in a way that could put downward pressure on energy prices. And even in the Bank of Canada’s own outlook, the call that inflation is going to be a problem is really all tied to the spillover from high oil prices. And on the trade front, if things get worse as opposed to better, or even I would argue if tariffs stay the same, we may have enough of an economic slowing on the trade side to basically do the job of containing inflation. So I would have waited, but the reality is if it turns out that this rate hike was unnecessary, there is no law against the Bank of Canada reversing course. So if oil prices come down and trade policy gets worse, they could always cut interest rates down the road and they’d be prepared to do that. So yes, I think that they could have waited and I would have taken that approach, as many economists are arguing, but I don’t think it’s a serious risk to the economic outlook because it is a decision that could be reversed if need be.

Helen Lao: Now, since they hiked earlier than, you know, at least core inflation data might have dictated, what does that tell us about how far the Bank of Canada is likely to take this tightening cycle?

Avery Shenfeld: Well, I think in part, remember that their view is also that moving earlier perhaps reduces the risk that they’ll have to move more aggressively later on, because they’re getting some slowing effect on demand earlier by doing this. So I think that that at least theoretically is correct. If you move earlier, you don’t need to move as far to get some headwinds against demand and therefore against inflation. But they also did give us a few clues that they are going to take this in somewhat of a measured pace. You know, they indicated that the discussion was about whether to hike or to hold. So they were at least considering pausing and waiting and seeing. They also dropped the words that they had used in previous warnings where they talked about high energy prices necessitating back-to-back moves in interest rates. There was no reference to the back to back move. There was a reference to, you know, the reasonable chance that they might have to move again, but they didn’t sound committed to moving again at the very next meeting, which to me suggests that having moved once, they’ll want to follow the data and let the data tell them whether to move again. So they’re left room certainly to space out these interest rate hikes. And therefore, again, that leaves me some comfort that they’re not going to hike repeatedly and then find out that that was a mistake because the economy is slower or inflation undershoots their forecast. You know, they’re willing to give some time to let the data prove how far they have to go. And so in our forecast, they do only have, you know, we don’t really see a lot of reason for them to hike aggressively. And we’ve for now at least, kept in a pause in December and making the next judgment in Q1 when we get more data.

Helen Lao: So this time with the policy decision, they also pushed out this new forecasting model, PRIMA. What surprised you about the bank’s forecast using this model as it laid out in the monetary policy report?

Avery Shenfeld: Well, the governor had warned in his comments to the media that they would be substantially raising their inflation forecast. And indeed they did that. But it was some of the details of that forecast that were a bit puzzling to us in the sense that the energy driver for inflation kind of fades off. And yet the impact of an energy shock that starts to dissipate on other prices, things like core goods prices, seems very far stretched out. You know, they avoided publishing a forecast for CPI excluding food and energy, for example, but some of the details that they lay out suggest that that sort of measure of core inflation will remain very elevated right through 2027. And to me, that’s putting a little too much emphasis on cost push inflation and not enough evidence on the demand side of the economy and the slack in the economy that acts as a cushion against businesses’ ability to pass on all these costs. And, you know, they’re relying on a new forecasting model which does seem to really emphasize these sorts of upstream costs in what happens to downstream consumer prices. But it’s showing up in services that don’t seem to us to be particularly sensitive to some of that. And it’s showing up with a lot of persistence relative to what you would expect with an economy that has some slack in it, even in the Bank of Canada’s own forecast. And curiously, they do publish some details on how their model is tracking, which actually suggests that in recent quarters, their model is already overstating or overestimating where inflation would be. So that to me, maybe this is just about making it clear that they had good reason to raise interest rates, which is, of course, is not popular among the Canadian public. And it doesn’t, again, worry me that they’re going to continue to overreact because for now they’re moving on a forecast. As the months roll by, they will be judging whether or not that forecast is in fact panning out. So again, if the actual data don’t nearly show the same degree of spillover into core inflation, and as I said, that spillover seems quite large to us, then they have plenty of time to adjust their forecasts and not overdo it on interest rate hikes. So this is about messaging why they’re doing this. They needed to lay out a case where inflation looked problematic enough to justify it, but I think that they might be overdoing it a bit.

Helen Lao: So where do you see the overnight rate going from here? And where do the risks lie in terms of seeing a more or fewer rate hikes than in the CIBC forecasts?

Avery Shenfeld: So we have one more hike in our forecast, probably in January, under the assumption that the US will not have gone ahead with the threat to put a 50% tariff on autos and parts that Trump threatened for January first. Because if that happens, that would be a disincentive to hike again. And also, though, only one hike under the assumption that at some point in the next few months, either with or without a war heating up again. The US and Iran will get back to a more diplomatic solution that has the central bank more comfortable with the idea that both oil prices and oil product prices like diesel and gasoline will be heading lower rather than higher. There are risks on both sides of that forecast. Anytime your forecast involves predicting what Donald Trump might do, have a lot of uncertainty associated with them. A more protracted oil price shock, or in fact, if an active war ends up lasting longer and takes out more refining capacity through counterattacks by Iran on some of the other Persian Gulf countries, you’re going to see more oil inflation and likely even in Canada, more interest rate hikes than that one additional one that we’re talking about. The contrary scenario is that we get a resolution of the oil inflation sooner, and that there is no resolution to trade frictions, in which case the Canadian economy might not be doing well enough to justify even that one additional rate hike. So there are risks on either side. They’re probably tilted to perhaps one more rate hike than we’re forecasting just because of the oil story and the Bank of Canada’s hawkish take on that, but I can’t see too much likelihood that the bank would hike as many times as the market was pricing in unless this energy shock inflation proves to be quite a bit worse than we’re thinking it will be.

Helen Lao: Thank you. I think we’ll wrap things up here. Thanks for joining us for this edition of our podcast. Until next time, we’ll be keeping our eyes on the economy and calling it as we see it.

Outro: Please join us next time on the Eyes on the Economy, where we will share our latest perspectives and outlook for the Canadian and US economy.

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One hikes, one holds: What’s next for rates?

CIBC Economics

Avery Shenfeld

Managing Director and Chief Economist

CIBC Capital Markets

Helen Lao

Executive Director, Economics

CIBC Capital Markets

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