Interest Rate Policy in Canada and US Poised to Diverge: An Examination of Two Economies

Experts suggest that with monetary policy at the Bank of Canada and U.S. Federal Reserve set to diverge, it could lead to volatility for the Canadian dollar in the future.

Allan Small, senior investment adviser at IA Private Wealth, mentioned that if the Bank of Canada’s rate falls significantly below the Fed’s rate, it could have a negative impact on the Canadian dollar. This could result in higher costs for imports from the U.S., Canada’s largest trading partner, and potentially lead to inflation pressures, although this would not happen immediately.

Small noted, “If the Bank of Canada cuts rates a few times and the Fed maintains its position, it may not pose a problem.” However, if the divergence continues with multiple cuts by the Bank of Canada and no action from the Fed into early next year, significant divergence might occur.

The U.S. Federal Reserve is expected to keep its key interest rate steady on June 12, given the resilience of the country’s economy despite higher borrowing costs and inflation pressures.

On the other hand, the Bank of Canada recently announced its first interest rate cut in over four years after a period of rate hikes aimed at controlling inflation.

Related Stories

During a press conference on June 5 discussing the rate cut, governor Tiff Macklem stated that the central bank is more confident that inflation is moving towards its two percent target.

Macklem acknowledged the limitations on how far the Bank of Canada can diverge from the U.S. in terms of rate policy, but mentioned that they are not currently close to those limits.

The Bank of Canada reduced its key lending rate by a quarter point to 4.75 percent, while the U.S. federal funds rate ranges between 5.25 percent and 5.5 percent.

Canada’s economy is particularly sensitive to interest rates due to the prevalence of five-year mortgage terms among Canadians, compared to 30-year terms in the U.S., according to Brianne Gardner, senior wealth manager at Velocity Investment Partners, Raymond James Ltd.

This discrepancy has resulted in a larger number of Canadian homeowners having to renew their mortgages during this period of higher rates, leading to reduced consumer spending.

Mr. Small described the situation as “a tale of two economies,” highlighting the Canadian market’s dependence on commodities like oil, in contrast to the U.S., where tech firms have a significant presence in financial markets and have been driving recent equity rallies on the back of optimistic views on artificial intelligence.

Gardner also noted that while it is not unusual for overnight rates to diverge slightly between the two countries, historically a difference of around 100 basis points has been considered a comfortable range.

She added that if the difference exceeds this threshold, a reassessment might be necessary.

Gardner expressed that there could be more room for divergence than commonly anticipated, citing past instances when the rate difference between the two nations reached as high as 250 basis points.

During such periods, strength in energy prices supported the Canadian dollar, providing a cushion against economic pressures.

Market expectations at the start of 2024 suggested the Federal Reserve might implement six rate cuts throughout the year, a forecast that has since been revised downward following economic data trends over the last six months.

Currently, there is a leaning towards a potential rate cut by the Fed in September in the U.S., although this outlook could change based on economic developments.

Small believes that if the U.S. economy performs well in the coming months, the Fed may delay any rate cuts until 2025.

Noting that the Bank of Canada makes interest rate decisions on a meeting-by-meeting basis, Macklem indicated that further rate cuts could be expected if inflation continues to ease and confidence in reaching the two percent target strengthens.

Although the Bank of Canada mentions having room to diverge, Small expressed uncertainty about the extent of that leeway.

He warned that if the U.S. refrains from making rate cuts, potential difficulties could arise in the future.