The central banks have been a topic of debate lately due to the potential divergence in interest rate policies. The Bank of Canada is expected to cut interest rates three times ahead of the Federal Reserve’s first move, according to a poll of analysts. The weakening Canadian dollar has sparked discussions about how much the BoC would be willing to diverge from the Fed. Currently, the BoC’s benchmark interest rate sits 38 basis points below the midpoint of the range set by the Fed for its policy rate.
There is a concern that a declining currency could endanger the inflation outlook. The latest data shows that inflation in Canada is at an annual rate of 2.9%, down from a peak of 8.1% in June 2022. The Canadian dollar has already weakened nearly 3% against the U.S. dollar since the beginning of the year, which could lead to higher import costs.
The exchange rate between the Canadian dollar and the U.S. dollar plays a crucial role in the monetary policy decisions of the Bank of Canada. While there is a theoretical limit to how far the BoC can set its policy rate below the Fed funds rate, there is still some room for divergence. Import costs could rise if the currency weakens further, putting pressure on the central bank to lower inflation to its 2% target.
The Canadian economy has lagged behind the U.S. economy in recent quarters, leading to debates about the appropriate timing of interest rate moves. The Organization for Economic Co-operation and Development (OECD) projects that Canada’s economy will grow only 1% this year, compared to the 2.6% forecasted growth rate for the United States. The interest rate gap between the two countries has remained relatively stable since the global financial crisis of 2008-09.
While there is a limit to how far U.S. and Canadian interest rates can diverge, analysts believe that the current level is not close to that limit. The central banks have some room to maneuver, especially if there are significant changes in the economic outlook. Factors such as household debt levels and mortgage renewals could influence the BoC’s decision to diverge from the Fed’s policy.
The potential divergence in interest rate policies between the Bank of Canada and the Federal Reserve has raised concerns about the impact on inflation and economic growth. While there is still room for the central banks to make independent decisions based on economic conditions, it is essential to monitor the exchange rate, inflation outlook, and overall economic performance to assess the need for policy adjustments.