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The Bank of Canada's final policy update for 2023, as reported by Bloomberg, had a relatively muted impact on the performance of the Canadian dollar, particularly when compared to previous instances of BoC policy decisions throughout the year. The USD/CAD pair experienced a modest move of -0.06% within the first 30 minutes following the announcement, representing the smallest percentage change in this currency pair following a BoC policy decision in the current calendar year.
Despite the updated policy guidance, which did not bring significant alterations to market expectations, there remains a prevailing sentiment that the BoC will likely embark on a rate-cutting cycle in the coming year. The Canadian rate market continues to fully price in the probability of the first-rate cut occurring at the April policy meeting. Furthermore, market participants are anticipating a cumulative reduction of around 110 basis points in interest rates by the end of the following year. This aligns with similar expectations for the Federal Reserve, reflecting a historical trend where the BoC and the Fed have tended to adjust their policies concurrently.
The BoC's policy guidance continues to signal a willingness to raise the policy rate if deemed necessary. However, recent economic indicators, including signs of slowing inflation and weak economic growth, have cast doubt on the necessity of maintaining the current restrictive policy rate. The policy rate, currently standing at 5.00%, already surpasses the BoC's estimated neutral rate range of 2.00% to 3.00%. In its updated policy statement, the BoC acknowledged that higher interest rates are impeding spending, with consumption growth near zero in the last two quarters and business investment essentially flat over the past year. This data provides the BoC with increased confidence that Canada's economy has shifted into a state of modest excess supply in Q4, a trend expected to persist through most of 2024, as previously forecasted in the October Monetary Policy Rate.
This economic development is expected to have a dampening effect on inflation pressures in the coming year. The updated policy statement acknowledges that the economic slowdown is reducing inflationary pressures across a broader range of goods and services prices. Headline inflation, which retreated to 3.1% in October, is projected to fall back within the BoC's target range of 1.0% to 3.0% in the coming months. The Governing Council, however, remains cautious and expresses the need to witness further and sustained easing in core inflation before becoming more confident in considering a reversal of the current restrictive policy stance. This cautious approach renders the Canadian dollar vulnerable to potential weakness in the early part of the next year if evidence of a slowdown in both economic growth and inflation continues to accumulate.
Turning to the foreign exchange market, after an unsuccessful attempt to breach the 1.3900-level at the beginning of November, the USD/CAD pair has retraced and is currently hovering around the 1.3500-level. This recent movement aligns with our short-valuation model estimate, indicating that the current valuation of the pair is reasonable based on crucial fundamental drivers. However, it's noteworthy that the model's fair value for USD/CAD has been gradually increasing since the summer. This upward trend is primarily attributed to the ongoing decline in oil prices and the building expectations for more assertive rate cuts by the Bank of Canada in the future.
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