According to the median estimate of seven analysts in a recent straw poll, the Bank of Canada is willing to cut interest rates three times before the Federal Reserve makes its first move. The decline in the Canadian dollar relative to the U.S. dollar has raised concerns about its impact on the inflation outlook, prompting speculation about how much the BoC is willing to deviate from the Fed’s policy.
Investors are anticipating that the Bank of Canada will begin cutting rates in either June or July, with next Tuesday’s inflation data seen as a crucial factor in the decision-making process. In contrast, the Federal Reserve is expected to maintain its current interest rates until September, despite lower-than-expected inflation figures in the U.S. recently.
The BoC’s benchmark interest rate already sits 38 basis points below the midpoint of the range set by the Fed, creating a potential pressure point for the Canadian dollar. However, analysts believe that significant movements in the currency would be necessary to threaten the central bank’s goal of achieving a 2% inflation target.
The latest data shows that inflation in Canada was at an annual rate of 2.9% in March, down from a peak of 8.1% in June 2022. The weakening Canadian dollar has resulted in a nearly 3% depreciation against the U.S. dollar since the beginning of the year. Economists predict that a 10% drop in the loonie could lead to a 2.5% increase in core goods prices, impacting approximately 30% of the Canadian CPI basket.
Bank of Canada Governor Tiff Macklem has acknowledged that there is a limit to how far Canadian interest rates can diverge from their U.S. counterparts. However, with the Canadian economy trailing behind the U.S. in terms of productivity growth and burdened by higher household debt levels, some argue that a divergence in interest rates may be necessary.
The OECD projects that Canada’s economy will grow by only 1% this year, significantly less than the 2.6% forecast for the United States. Despite the interest rate gap remaining relatively stable since the global financial crisis of 2008-09, there is still room for divergence between the Bank of Canada and the Federal Reserve if economic conditions in Canada deteriorate.
Economic factors such as mortgage renewals and household debt levels could provide the Bank of Canada with the opportunity to diverge from the Fed’s interest rate policy if needed. While there are constraints to how far interest rates can differ between the two countries, a changing economic landscape may necessitate a shift in policy direction.
The Bank of Canada’s willingness to cut interest rates multiple times ahead of the Federal Reserve reflects the challenges faced by the Canadian economy and the need to maintain inflation targets. Despite the constraints imposed by interest rate differentials, economic conditions may require divergent policy actions to support growth and stability in the Canadian economy.