The Bank of Canada is considering the possibility of cutting interest rates three times before the Federal Reserve makes its first move. This decision comes as the Canadian dollar weakens against the U.S. dollar, raising concerns about the impact on the inflation outlook. Analysts predict that the BoC may begin rate cuts in June or July, with the upcoming inflation reading playing a crucial role in this decision-making process.
The BoC’s benchmark interest rate is currently 38 basis points below the midpoint of the range set by the Fed for its policy rate. This existing differential has led to discussions about the extent to which the BoC can diverge from its U.S. counterpart. A larger gap in interest rate differentials could further depreciate the Canadian dollar and increase pressure on the economy. However, analysts believe that it would require a significant depreciation in the currency to impact import costs enough to jeopardize the central bank’s inflation target of 2%.
Recent data shows that inflation in Canada has decreased to an annual rate of 2.9% in March, down from a peak of 8.1% in June 2022. The weakening Canadian dollar, which has fallen nearly 3% against the U.S. dollar since the beginning of the year, has contributed to this decline. An analysis suggests that a 10% depreciation in the Canadian dollar could lead to a 2.5% increase in core goods prices, highlighting the potential impact of exchange rate fluctuations on inflation.
The Canadian economy has been trailing behind its U.S. counterpart in recent quarters, with factors such as lower productivity growth, higher household debt levels, and a shorter mortgage cycle weighing it down. This underperformance has raised questions about whether the BoC should act preemptively and cut interest rates ahead of the Federal Reserve. The OECD expects Canada’s economy to grow by 1% this year, significantly less than the forecasted 2.6% growth rate for the United States.
Future Policy Decisions
Although there is a limit to how far U.S. and Canadian interest rates can diverge, the current gap of 100 basis points may not be a binding constraint if the Canadian economic outlook deteriorates in the latter part of 2024. Factors such as unexpected strains on the household sector from mortgage renewals could provide the BoC with more flexibility to deviate from the Fed’s monetary policy. Bank of Canada Governor Tiff Macklem has acknowledged the possibility of further divergence in interest rates, emphasizing that the central bank has room to maneuver to support the economy.
The Bank of Canada’s potential interest rate cuts in comparison to the Federal Reserve reflect the central bank’s efforts to manage economic challenges and maintain price stability. The decision to potentially cut rates multiple times underscores the importance of proactive monetary policy measures in response to evolving economic conditions and external factors. As the global economic landscape continues to evolve, central banks must remain vigilant and adaptable to support sustainable growth and economic resilience.