‘A Tale of Two Economies’: Interest Rate Policy in Canada And US Diverging
The comments below are an edited and abridged synopsis of an article by Rosa Saba,The Canadian Press
The divergence in monetary policies between the Bank of Canada (BoC) and the US Federal Reserve (Fed) could lead to increased volatility for the Canadian dollar, according to financial experts. Recently, while the Fed opted to hold its key interest rate steady, the BoC announced a rate cut. This difference in policy direction may have significant implications for the Canadian dollar (loonie) in the near future.
Impact of Diverging Rates
Allan Small, senior investment adviser at IA Private Wealth, warns that if the BoC’s rate falls significantly below the Fed’s, the loonie could be negatively affected. A weaker Canadian dollar would make US imports more expensive and put upward pressure on inflation in Canada. While a few rate cuts from the BoC might not pose immediate problems, sustained cuts against a stable Fed rate could lead to significant divergence, impacting the currency’s value.
Economic Resilience and Rate Cuts
The US economy has shown resilience against higher borrowing costs and inflation, prompting the Fed to maintain a cautious approach. Fed Chair Jerome Powell emphasized the need for more positive economic data to confirm a sustainable move toward the 2% inflation target. Conversely, Canada’s economy has shown signs of needing relief, prompting the BoC to cut its key lending rate for the first time in over four years. BoC Governor Tiff Macklem expressed confidence that inflation in Canada is moving towards the 2% target, justifying the rate cut.
Sensitivity to Interest Rates
The Canadian economy’s sensitivity to interest rates is partly due to the shorter mortgage terms prevalent in the country. Unlike the US, where 30-year mortgage terms are common, Canadian homeowners typically have five-year terms, leading to more frequent mortgage renewals and adjustments to higher rates. This has resulted in reduced consumer spending as many Canadians face higher mortgage payments.
Sectoral Differences
The economic structure of Canada and the US also contributes to their differing monetary policies. The Canadian economy is more reliant on commodities like oil, whereas the US economy has significant exposure to the technology sector, which has seen a rally driven by optimism around artificial intelligence. This difference gives the US a competitive edge in terms of economic growth and stability.
Historical Perspective and Future Projections
Historically, a difference of up to 100 basis points between the BoC and Fed rates has been considered manageable. However, there have been periods, such as in the 1990s, where the gap was as wide as 250 basis points. During that time, strong energy prices helped support the loonie. If energy prices rise again, they could provide a buffer for the Canadian dollar against any adverse effects of rate divergence.
Market Expectations and Economic Outlook
At the beginning of 2024, market expectations were for multiple Fed rate cuts throughout the year. However, as economic data has been more robust than expected, these expectations have been adjusted. The Fed now projects just one rate cut in 2024, and there is a possibility that rate cuts may be delayed until 2025 if the US economy remains strong.
The BoC, on the other hand, is taking a cautious approach, with Governor Macklem indicating that future rate cuts will depend on continued progress toward the inflation target. This measured approach underscores the uncertainty surrounding how much divergence the Canadian economy can sustain without significant repercussions.
In conclusion, while the BoC believes there is room to diverge from US monetary policy, the extent of this divergence remains uncertain. The potential volatility for the Canadian dollar will depend on various factors, including domestic economic resilience, energy prices, and broader global economic conditions.