The Bank of Canada is poised to reduce its benchmark interest rate multiple times before the Federal Reserve begins to lower its rates, according to economists, who suggest this move could mitigate concerns about a growing policy rate gap between the two central banks.
For nearly two years, the United States has experienced stronger economic growth compared to Canada. This trend, according to economists from CIBC Capital Markets and TD Economics, provides Bank of Canada Governor Tiff Macklem with the confidence to ease borrowing costs more aggressively than the Fed.
It is widely anticipated, though not unanimously, that the Bank of Canada will reduce its overnight rate by 25 basis points to 4.75 percent on June 5. Factors such as declining inflation figures for April and a slowdown in first-quarter GDP growth support the case for a rate cut. Conversely, in the United States, a robust services sector and increased government spending have maintained pockets of inflation, leaving Fed officials uncertain about the timing of their rate cuts.
James Orlando of TD Economics expects Canada’s real GDP growth to remain less than half of that in the U.S. throughout 2024, reinforcing the Bank of Canada’s decision to cut rates.
“Below-trend growth in Canada should make the Bank of Canada confident that it has inflation under control,” he wrote. “The Fed, however, does not have this luxury.”
Ali Jaffery of CIBC forecasts two 25 basis point cuts by the Bank of Canada before the Fed begins lowering interest rates in the U.S. in September.
“We predict 100 basis points of cuts in Canada, which will be double the rate seen in the U.S., widening the current spread up to one percent,” Jaffery wrote in a research note published on Monday. “The Bank of Canada could implement two to three cuts before the Fed and manage a 100 basis point gap for some time.”
TD Economics predicts the Bank of Canada will start reducing rates this summer, accelerating the pace of cuts towards the end of 2024. They expect the Fed to begin cutting rates in December.
“This would mean the spread between the Bank of Canada and Fed policy rates could reach 125 basis points before the Fed begins accelerating its own rate cuts,” Orlando wrote in a research note last week. “This suggests that the Bank of Canada will manage its monetary policy based on domestic conditions while keeping an eye on developments in the U.S.”
Despite historically moving in tandem, Canada’s economic performance has lagged behind that of the U.S. in recent years.
Jaffery points out that the primary concern in limiting divergence between the Bank of Canada and the Fed is the inflationary impact of a weaker Canadian dollar. He argues this would be a more significant issue if both economies were equally strong.
“Canadian importing firms have limited ability to pass higher prices onto consumers and may have to absorb some of the increased import costs through lower margins. Thus, the inflationary impact should be smaller compared to a scenario where both economies were robust,” he wrote. “As the Bank of Canada explores the extent to which it can diverge from the Fed, it should currently have the freedom to pursue its own course.”
Orlando hopes Macklem will not be overly influenced by factors from the U.S. when determining the path of interest rates in Canada.
“If there’s one lesson we’ve learned since central banks began hiking rates, it’s that interest rates affect economies differently,” he wrote. “The Canadian central bank needs to respond to domestic