'A tale of two economies': Interest rate policy in Canada and U.S. set to diverge

With monetary policy at the Bank of Canada and U.S. Federal Reserve on track to diverge, experts say it could set the Canadian dollar up for volatility down the road.

If the Bank of Canada's rate falls too far below the Fed's, it could negatively affect the loonie, said Allan Small, senior investment adviser at IA Private Wealth. This would make imports from the U.S.-- Canada's biggest trading partner -- more expensive and put upward pressure on inflation, though he added this isn't something that happens overnight.

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"If the Bank of Canada cuts a few times and the Fed stands pat, I don't think that will be an issue," he said.

But if the Bank of Canada keeps cutting and the Fed holds on past the first quarter of next year, "then we could start to see significant divergence."

The Fed is widely expected to hold its key interest rate steady on Wednesday as the country's economy has been more resilient than expected in the face of higher borrowing costs and inflation.

It's a different story in Canada, where last week, the Bank of Canada announced its first interest rate cut in more than four years after a steep hiking cycle aimed at tamping down inflation.

At a June 5 press conference discussing the rate cut, governor Tiff Macklem said the central bank has more confidence that inflation is heading toward its two per cent target.

He acknowledged there are limits to how far the Bank of Canada can diverge from the U.S. in terms of rate policy, but he said "we're not close to those limits."

The Bank of Canada cut its key lending rate by a quarter of a percentage point to 4.75 per cent while the U.S. federal funds rate currently sits at 5.25 per cent to 5.50 per cent.

Canada's economy is more sensitive to interest rates, in large part because Canadians have five-year mortgage terms, while in the U.S., terms are 30 years, said Brianne Gardner, senior wealth manager of Velocity Investment Partners at Raymond James Ltd.

This means far more Canadian homeowners have had to renew their mortgages during this period of higher rates, which has led consumers to rein in their spending.

"It's really a tale of two economies," said Small.

The Canadian market also depends more on commodities like oil, said Small, whereas tech companies make up a large portion of financial markets in the U.S. -- and major tech names have been leading a recent rally in equities over optimism about artificial intelligence.

"That has gone a long way to produce the earnings, to produce the growth, and to give the United States a definite advantage," said Small.

It's not uncommon for the overnight rates between the two countries to diverge somewhat, said Gardner, but it's not usually a significant difference.

Historically, a difference of 100 basis points, or one percentage point, has been a "comfort zone," she said.

"If there is that window, I would say we're still comfortable with that. If it starts to get a little bit outside that, I think we might reassess."

"I think there's more room for divergence than most people think," said Gardner.

For a period in the 1990s, the difference between the two rates was 250 basis points, which is "quite a large spread," said Gardner.

During that period, however, strength in energy prices helped buoy the loonie, said Gardner.

"If energy prices continue to rise, that could be a buffer for the Canadian dollar."

At the beginning of 2024, market watchers thought the Fed could cut its key rate six times throughout the year, even though the central bank itself was projecting three cuts. Those expectations have been significantly pared back as economic data rolled in over the past six months.

Bets are now leaning toward a first cut in September in the U.S., said Gardner, but the economic data could change that.

Small says depending on how the U.S. economy holds up as the year progresses, it's possible the Fed won't cut at all until 2025.

However, investors hoping for lower rates got a boost of optimism Wednesday morning as they waited for the central bank's decision later in the day. A new report showed consumer price inflation in May eased for the second straight month, coming in at 3.3 per cent compared with what economists expected, which was 3.4 per cent.

Macklem said last week that the Bank of Canada is taking its interest rate decisions "one meeting at a time."

• The latest on inflation in Canada

"If inflation continues to ease, and our confidence that inflation is headed sustainably to the two per cent target continues to increase, it is reasonable to expect further cuts to our policy interest rate," he said.

"The Bank of Canada says that they have a lot of room to diverge," said Small, but he added it's not clear how much room that actually is.

"At some point, if the U.S. does not start cutting ... it could present some difficulty, for sure."

-- With files from The Associated Press

This report by The Canadian Press was first published June 12, 2024.