Economists suggest that the robust performance of the U.S. economy could delay interest rate cuts in Canada, as the Bank of Canada seeks to align its policies with the United States Federal Reserve.
Canada’s economy showed signs of improvement at the end of 2023, with Statistics Canada reporting growth in real gross domestic product in November and December. This sets the stage for a rebound in the fourth quarter after a contraction in the third.
Despite this progress, the U.S. economy continues to outperform Canada, with fourth-quarter GDP growth reaching 3.3 percent annualized. In contrast, Canada was initially forecasting only 1.2 percent annualized growth in the fourth quarter.
Both countries have tightened monetary policy to combat inflation, with success in cooling inflationary pressures, although neither central bank has achieved its two percent inflation target. If the economy remains overheated and poses a threat to reaching the two percent inflation target, interest rates could stay elevated for an extended period.
The difference in economic resilience between the two countries can be attributed to the strong consumer spending in the United States, which has defied expectations. Canadian households, on the other hand, are more vulnerable to higher interest rates due to their significant debt levels. While U.S. consumers reduced their debt following the 2008-09 financial crisis, Canadians continued to accumulate debt. Canada’s household debt servicing ratio reached an all-time high of 15.2 percent in the third quarter of 2023.
The impact of higher interest rates on Canadian households is evident in reduced per capita spending, as indicated by an RBC consumer spending report. Additionally, mortgage renewals are looming as a concern in Canada, while longer mortgage terms in the United States offer more insulation against rising interest rates.
The transmission of monetary policy into the Canadian economy is faster, making it more susceptible to rate changes. Meanwhile, the strong growth in the United States has begun to spill over into certain sectors in Canada, particularly goods-producing industries like manufacturing and wholesale trade.
After the release of stronger-than-expected GDP figures, market expectations for a Bank of Canada rate cut in April were reduced, with calls for easing starting in June. In contrast, the U.S. Federal Reserve, while considering future rate cuts, is in less of a hurry to implement them, given the strength of its economy.
Although the Bank of Canada and the Federal Reserve are independent in setting monetary policy, they tend to move in sync due to the exchange rate between the Canadian dollar and the U.S. dollar. If the Bank of Canada were to cut rates more quickly, it could lead to a depreciation of the Canadian dollar, affecting exports and potentially causing an inflationary shock from more expensive imports.
While the Bank of Canada is expected to make rate cuts earlier than the Federal Reserve due to Canada’s economic weakness, the overall direction of both central banks remains aligned, reducing concerns of inflationary shocks due to a slight timing difference.
In summary, the strong U.S. economy and the potential delay in rate cuts in Canada highlight the importance of monitoring economic developments on both sides of the border to assess their impact on monetary policy and exchange rates.
