BoC expected to trim interest rate again as markets seek clues on uncertain economic outlook

• Bank of Canada (BoC) is expected to cut its policy rate by 25 bps.
• The Canadian Dollar remains on the defensive against the US Dollar.
• Headline inflation in Canada remains below the bank's 2% target.
• The BoC will also release its Monetary Policy Report (MPR).

The spotlight is on the Bank of Canada (BoC) this Wednesday, with widespread expectations that it will lower its policy rate for the sixth meeting in a row. This time, however, the buzz surrounds a potential 25-basis-point cut--a smaller move than in the previous couple of gatherings--which would bring the benchmark rate down to 3.00%.

Meanwhile, the Canadian Dollar (CAD) has embarked on a consolidative phase since mid-December, looking to stabilise following yearly lows north of the 1.4500 level vs. the US Dollar (USD), and the sharp depreciation that kicked in along with the so-called "Trump trade" back in October.

Canada's inflation story adds an intriguing layer to the BoC's rate decision. December marked the second consecutive pullback as the annual inflation rate, measured by the headline Consumer Price Index (CPI), dipped to 1.8%. Although the BoC's core CPI edged up last month, it remains below the central bank's goal.

Further easing appears on the cards

Despite the anticipated rate cut, the Bank of Canada is expected to maintain a bearish outlook. This sentiment comes against the backdrop of easing inflation, a softening labour market and GDP hovering close to the bank's most recent forecasts.

In the BoC's Business Outlook Survey published on January 20, Canadian businesses are cautiously optimistic about the year ahead. They expect better demand and stronger sales, thanks in part to recent rate cuts. However, many are keeping a wary eye on potential fallout from upcoming United States (US) policies.

According to the Minutes released on December 23, the BoC's decision to cut rates by 50 basis points on December 11 was a tight call, with some members of the governing council leaning toward a smaller reduction. Discussions among council members revolved around whether a 50 or 25 basis point cut was the right move. Those advocating for a larger cut were particularly concerned about weaker growth projections and downside risks to inflation. However, they acknowledged that not all recent data fully supported such an aggressive move.

Ultimately, the decision to opt for a 50 basis point cut was driven by a dimmer growth outlook than anticipated in October and the recognition that monetary policy no longer needed to remain firmly restrictive.

The central bank lowered its key policy rate to 3.25% in response to slowing economic growth. Governor Tiff Macklem signaled that any future rate cuts would be more measured, marking a shift from earlier statements that emphasized the need for continuous easing to bolster the economy.

Previewing the BoC's interest rate decision, Assistant Chief Economist at Royal Bank of Canada Nathan Janzen noted: "The Bank of Canada is expected to cut interest rates at a more gradual 25 basis-point pace on Wednesday following 50 bps cuts in each of the two prior meetings--widening a gap with US policy rates as the Federal Reserve is widely expected to forego a January rate cut... The BoC clearly communicated in its December policy decision that with the interest rate no longer at obviously 'restrictive' levels, the pace of future rate cuts would likely be more gradual, and contingent on economic data... We continue to expect the BoC will ultimately need to cut the overnight rate to a slightly stimulative 2% this year." 

When will the BoC release its monetary policy decision, and how could it affect USD/CAD?

The Bank of Canada is set to announce its policy decision on Wednesday at 14:45 GMT, followed by a press conference from Governor Tiff Macklem at 15:30 GMT. While no major surprises are expected, market focus will likely be on the central bank's tone, which could have a bigger influence on the Canadian Dollar (CAD) than the actual rate decision.

Pablo Piovano, Senior Analyst at FXStreet, highlights that USD/CAD now appears sidelined in the upper end of the recent range, following a strong upward trajectory in place since October, with the pair reaching a 2025 peak at 1.4516 on January 21.

Looking ahead, Pablo notes: "The next key target is the 2020 high at 1.4667, recorded on March 20."

He also points out potential downside levels, saying: "Occasional bearish moves could push USD/CAD to test the 2025 bottom of 1.4260 (January 20), while provisional contention emerges at the 55-day and 100-day SMAs at 1.4226, and 1.3989, respectively.