The Bank of Canada will need to play very safe in its easing cycle, despite widespread expectations of an immediate July rate cut, and take a much slower path due to the high risks from persistent inflationary pressures, economists said.
Canada's currency depends heavily on trade with the United States, high housing demand poses a constant threat of a surge in house prices and the country's wage inflation has been ticking faster than the rate of growth of consumer prices.
Economists and analysts said if a faster interest rate cut triggers inflationary pressures due to these factors, it could reverse the success seen on inflation.
"I think they (BoC) should be and they still are very concerned about whether they will get inflation down all the way," said Pedro Antunes, chief economist at Conference Board of Canada, an independent think tank.
The announcement fueled expectations for a back-to-back rate cut in July and further reduction to 4% this year.
But if the bank moves ahead with consecutive cuts, it could trigger inflation.
One of the primary worries is how interest rates pan out in the United States. This impacts the fight against inflation, Antunes said.
Canada's currency depends heavily on trade with the U.S., which accounts for two-thirds of its imports. When interest rates in Canada fall while they stay steady in the U.S., its currency weakens and imports tend to get costlier, driving inflation.
"We will see very slow declines in Canada (interest rates), in part, because of the kind of position that the Fed is still in," Antunes said.
Another factor the BoC should bear in mind, economists say, is to bring back a flood of housing demand as interest rates come down, said Craig Alexander, president of Alexander Economic Views, an independent economic research organization.
Canada's housing demand has mostly been sidelined due to high interest rates, but that has not changed the acute need to build houses at a rapid pace.
It will need to expand its housing stock by an average of 315,000 units every year between now and 2030 to meet this demand, according to an analysis by the Royal Bank of Canada.
Phil Soper, the CEO of Royal LePage, a real estate developer, told Reuters on Wednesday that the cut in interest rates would spark activity and put upward pressure on home prices in the second half.
Wages are also often cited by economists and analysts as a factor that could spur inflation once again.
The average hourly wage growth for permanent employees grew at 4.8% even as consumer price growth slowed to 2.7% in April.
"People are getting paid more. What's wrong with that? The problem is that we have a declining productivity in Canada per capita," said Brooke Thackray, research analyst with Global X, a fund management company.
Even though wage growth is considered a lagging indicator - that is, it does not predict a future trend - it nonetheless feeds directly into inflation numbers amid negative productivity, he said.
Bank of Canada Governor Tiff Macklem also acknowledged during his policy decision announcement that housing prices and wage growth could spell trouble for his efforts to tame inflation and bring down policy rates.
"I think it's going to be a very protracted rebalancing of monetary policy," said Alexander from Alexander Economic Views.
