This weekend and the start of the trading week were heavily impacted by President Trump announcing tariffs on Canada, Mexico and China. They were ultimately postponed for Mexico and Canada, but he has the EU in his sights as well This edition we discuss central banks in the context of tariffs, but also what the non-tariff fundamentals are suggesting for policy going forward. The Fed paused its cutting cycle just last week, while the BoC and ECB cut 25bp and the BoE looks poised to do so later this week.

Participants:

• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics
• Blake Gwinn (Desk Strategy), Head of US Rates Strategy
• Simon Deeley (Desk Strategy), Canada Rates Strategist
• Robert Thompson (Research), Macro Rates Strategist

* Research Analyst opinions are their published views, independent of those expressed by Desk Analysts

Jason Daw:

Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen till the end of this recording for important disclosures.

Peter Schaffrik:

Now, we recorded an edition of Macro Minutes just last week where we talked about the macro impacts of tariffs. This week, we want to specifically talk about central banks, in general given the state of the economy, but also against the backdrop of tariffs that have been introduced. We have four speakers on the call today. We've got Blake Quinn covering the US, we've got Simon Dealey to speak about the Bank of Canada. I will talk about the ECB and the Bank of England, and we are also fortunate to have Rob Thompson on the call who will share his views on the RBA.

So let's get started with the US. Blake, the Fed left rates unchanged, but that was last week. What do you think their thought process looks now as far as the economy generally is concerned, but also factoring in the tariff discussion?

Blake Gwinn:

So yeah, Peter, as you said, the Fed did start their pause last week at January's FOMC meeting. They remain very, very data dependent. At this point, I don't think they want to really take anything off the table. I think they're much more watchful. Powell said the economy's strong. He seemed to have a lot of confidence that inflation was going to continue to come back to 2%, and I think the broad sense in the committee is that they really just don't need to rush into anything. I think they're just taking their time, taking a very gradual approach, careful approach, and I think that really extends over into the tariff and trade conversation as well.

There's just a lot of uncertainty. I think we've seen over the events the last week or two that these trade headlines are very hard to make long-term predictions on. I think the Fed is in the same spot as most people in the market, which is that you just really have no idea how they're going to play out over the next six to 12 months. Is it going to be Canada, Mexico, and China? Is one of those going to be dropped? Are they going to expand to Europe? Are certain products going to be excluded? So just a lot of question marks on the actual path of tariffs.

You also then have to take into account escalations. Six months time, we could be deep into multiple rounds of tariffs and counter tariffs with other countries, so just a lot of ways that this could play out and I think it makes it very difficult for the Fed, because on top of that, even if you knew exactly how the tariff story was going to play out, you had a perfect roadmap for the next 12 months, even still, you'd have some uncertainty around what that's actually going to do to the data, and there, I don't think the Fed really has a relevant playbook. We don't have a lot of modern history to look back on with tariffs. You have to go pretty far back to periods where the Fed, their monetary policy framework and even the nature of the US economy looked wildly different, so I just don't think they're really that applicable.

One thing I've highlighted a few times to clients is just the US's increasing energy independence, that really changes the way a lot of these tariffs might work than they did in the past. The other thing I would say too is just that businesses, and I would say consumers as well, there is this post COVID inflation mindset. I think the way businesses would think about passing through price increases to their customers has changed post COVID, and I think also consumer's willingness... I wouldn't say willingness. People certainly aren't happy about it, but their acceptance I guess is maybe a better word of seeing price increases after the inflation of the last few years, so that mindset's very different and I think now versus prior instances is much more likely to spill over into inflation.

Simon Deeley:

Let me chip in here from the Canadian side. We are very clear over here that the tariffs have a large impact on GDP down and on inflation at least initially up. What does this do in the US? Trump seems to acknowledge that there would be short-term pain. How does the Fed think about it?

Blake Gwinn:

Yeah, thanks Simon. So I guess following up on that last question, I said the Fed is very uncertain, they remain very watchful. I think they're not going to be reactive, but they are going to be watching very closely in the data if we move further down this trade war path. It's very difficult by the time this publishes. Between when we recorded it and when it publishes, there may have been changes on that front, but the last we've heard is that we have had delays in both the implementation of both the Canada and Mexico tariffs, so that's what I'm operating with right now. So one of the things that I think the Fed is going to be looking for first is just longevity of tariffs.

If something goes into place for a couple of weeks and then we get an off ramp, that's not really going to be something the Fed cares about per se. I think where they might start to get concerned, even if we don't see those tariffs go into place or they last for a long time, is the uncertainty that it creates for businesses and consumers, and you saw Powell mention that in the January press conference. He did say that if this leads to prolonged and heightened uncertainty on the part of businesses, it could slow down CapEx, it could slow down investment, it could start to impact business and consumption decisions. So even if we don't see those tariffs get put into place, even if they don't last for a long time, even just the uncertainty could start to drag on growth, so that's I think one thing the Fed's going to be watching for.

One thing I don't think they're watching, or I should say that I think they're probably going to look through, is direct price increases on tariffed goods. That is a one-time price level shift. I don't think the Fed sees their rate policy as a very good tool to address those price increases, so I think we can write off one-time increases in prices or that initial pass-through to the goods that are getting hit by tariffs. What the Fed's really looking for is spillover price increases. If we start to see companies using those tariffs or using rising prices on those tariffed goods, if they start using that as cover to put through price increases on other goods, that's where I think the Fed's really going to get more concerned.

I actually tend to think that they're much more watchful and much more likely to react to implications on the growth and labor front than they are on the inflation and price front. I think they're going to be looking for demand destruction. If we see gas, food, other types of products, if we see those expenses going up for consumers, what does that do to their consumption of other goods? Are we just going to see this cannibalization of consumption as they have to spend more for gas every week or to fill the fridge up with groceries? So that's one thing that I think they're very sensitive to.

The last thing I would say is financial conditions. If we did see a big sharp move in risk assets, the first level would be some type of verbal intervention, they start saying in the statement that they're watchful of these types of conditions or start mentioning that in their speeches, but I think it's a very, very high bar to what it would actually take to get them to start moving rate policies to start delivering insurance cuts on financial conditions alone. So I think sometimes the market overvalues a little bit this idea of the fed put. The Fed would probably allow a pretty decent correction in risk assets before they actually got involved, but it is something else that I think they are going to be watching for on top of those other things that I mentioned.

So if I can, let's turn that back around to you, Simon. As I mentioned, I think from the Fed's perspective, these tariffs could have a much greater impact on the economies that they're being placed on versus the US. So we've got a very aggressive Bank of Canada call, we have for quite a while now. I think you guys are at the 2% terminal rate. Our chief economist, Francis Donald, she suggested GDP impact on Canada could be pretty large, so has this tariff back and forth on Canada over the last week, has that strengthened or has it weakened your conviction about where we come out on the Bank of Canada path?

Simon Deeley:

On the inflation front, recent core prints have been somewhat elevated but not enough to worry the BOC, and they expect inflation to remain close to 2% over the coming two years.

Peter Schaffrik:

Simon, a question that vexes me here in Europe a lot and that seems quite relevant for you as well. We've seen a universal strengthening of the dollar lately, and of course that implies a weakening of the Euro and Sterling in my case, and CAD in your case. How relevant do you think these moves so far are for the Bank of Canada, and if they're not significant yet, at what point would they become relevant?

Simon Deeley:

Relative to other central banks, the Bank of Canada is actually not as sensitive to exchange rate developments and tends to talk about them less frequently. There was an exception in last week's monetary policy report with them devoting a special section on explaining recent CAD depreciation. Their analysis showed that while some of the CAD depreciation versus the dollar was due to interest rate differentials, most of it was due to rising exchange rate risk, likely tariff-related. Many other countries have seen similar moves and it has driven broad-based dollar strength. Indeed, CAD has been relatively neutral more broadly as reflected by being roughly flat in its trade-weighted index ex-USD.

Moreover, the bank's own analysis suggests it takes a sizable move in the trade-weighted index, about 10%, to have a modest impact on core inflation, which would be a quarter percentage point. So we haven't gotten to those levels yet even on dollar CAD, but certainly on the trade-weighted index, the levels are not approaching that 10% number. This underlines why the bank has felt comfortable diverging from the Fed and why we think the exchange rate will not be a main factor of driving monetary policy going forward. To be clear, below 150 for dollar CAD and we think the BOC is reasonably comfortable, especially if moves are more fundamentally driven or part of a broader USD strength story.

Peter, let me turn to Europe. So far, we have not seen any actual tariffs on the European economies, but the rhetoric has already amped up. How does the ECB think about it and how has your thinking evolved since last Thursday's 25 basis point cut that was widely expected as far as their next moves are concerned?

Peter Schaffrik:

It's a very good question, Simon. So we haven't really seen any official analysis from the ECB, but we had a few speakers who have opined on it. Probably the most prominent were the Vice President de Guindos and also the French representative on the board, Villeroy, and both have essentially said the same thing. They have said that the near-term impact is probably inflationary, but that the medium-term impact is growth dampening and therefore probably disinflationary.

Now, they haven't really said how they would react to the short-term inflationary impact, but the inference is that they might be inclined to look through it and keep cutting. Now, my problem that I have with this view is that whilst this probably would have been the case 10 years ago, what we've learned in the recent inflation episode is that as unemployment is low and as wage growth is still quite ample, what we could see is if we have an inflationary impact, no matter where it comes from, if it does not lead to a broader increase in unemployment, it could well lead to an increase in wage demands in order to make up the lost gains in real term, and therefore perpetuate the inflationary problem, and that could ultimately be the thing that the ECB will be faced with.

Now therefore, my takeaway would be that the governing council would probably have at some point pause, which they probably will have to do anyway in their cutting and assess the situation and whether not there is a feed-through as they expect either in terms of inflation or in terms of growth, but that would require them to take a deep look at it and require time. So therefore, I do think ultimately, they cannot just look through it as they probably would like to.

Robert Thompson:

Let me also chip in here. Maybe not as dramatically as the RBA, but the BOE seems a bit behind the curve. What do you expect from the MPC this week? Can they remain as hawkish as they have been given the economic backdrop seems to be weakening by the hour?

Peter Schaffrik:

Yeah, thanks Rob. I think that's a great question on the bank. Now look, the bank has cut 50 basis points so far. Obviously, ECB has cut 125 specifically, and obviously others have been more aggressive as well. And I think the trade-off that the bank is continuously stressing is that on the one hand, we have relatively mediocre growth levels, but on the other hand, given the tightness of the economy and the intrinsic inflation pressures aren't going away. Now, one of the things that has happened since the start of the year as the bond market has rallied is that we have really increased the total amount of rate cuts that we're expecting for the Bank of England. Whereas before the turn of the year, we were pricing in 50 and less, we're now pricing round about 90, and that's obviously significantly more.

Now, one of the things that however has not happened is that we've been pricing a fairly speedy rate cut cycle, so we're still only pricing a good amount of probability for rate cuts to come in the so-called NPR meetings when they roll out new forecasts such as this week's. But the interim meetings, we're pricing them only with a relatively small probability, and this is really where we think the possible surprise this week could come from. If they do open the door, let's say for quicker rate cuts, back-to-back cuts, we think those inter-NPR meetings could really rise in implied probability for rate cuts, and therefore, the entire cutting cycle could be coming forward.

Now, that might increase the total amount of cuts that the market expects, but I don't think a great deal because the guidance on the total amount of cuts is probably going to stay unchanged. The question is really how quickly will they get there? And I think that's the question that will need to be answered this week.

Rob, the tariff issue is probably less relevant for you at present, but we had soft inflation prints last week on your side. Does that finally allow the RBA to begin the easing cycle?

Robert Thompson:

Well, the first order tariff impacts are less relevant given the US isn't a large trading partner for us, and we run a trade deficit there anyways, so we're not in Trump's immediate firing line, but second order impacts could still be quite material given our dependency on trade with China. So the potential for downside growth impacts is still there. Now though, it's indeed the inflation print that we're much more focused on for the RBA's upcoming meeting, and yes, we do think it'll allow the bank to finally begin their much-delayed easing cycle.

Core trimmed mean inflation came in well under consensus and RBA estimates printing just half a percent on the quarter. There was some subsidy impact even on the core measure, but looking through this, we saw mostly all the right things even on the non-tradable side and services too, including on shelter costs which are finally coming down.

Even if we get a bit of a tick back up over the next few quarters, we think the RBA will be comfortably able to forecast core inflation settling back into the two to 3% target range in the first half of this year, so earlier than the November forecasts. A 25 basis point cut is all but fully priced already, so you could argue there's some decent risk reward and positioning the other way for the February meeting, but we think the bank would love to cut and now has all the evidence it really needs to do so.

Blake Gwinn:

Hey Rob, I know we're getting pretty close to time here. This is already running a bit long, but I did have one final question. I think this might be applicable for most central banks anyway. So the February RBA meeting might have a green light, core inflation still above 3%, unemployment barely half a percent for the absolute lows. Can RBA really afford to take the cash rate anywhere near neutral at this point?

Robert Thompson:

The strength of the labor market does make it very difficult to justify more than two or three adjustment style cuts for the RBA. Compared to dollar block peers, our relatively low P cash rate and quite stimulatory fiscal policy, including a lot of non-market job creation, have kept employment outcomes remarkably strong. We swung back to three cuts from two after the inflation data, which would take us to a terminal rate of 3.6%. This is actually pretty close to where we sit neutral, but it's a high bar in our view to go any lower than this. It would take a much larger and likely externally driven shock to growth and/or the lead market to cut below this point.

Peter Schaffrik:

I think we'll wrap it up there today. That's all for this edition. Thank you everyone on the call and thank you everyone for listening, and hope to tune in again next time.

Speaker 6:

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