The gap between Canadian and U.S. interest rates has widened further after the Bank of Canada (BoC) cut its key lending rate by a quarter-point on Wednesday, while the U.S. Federal Reserve held its rate steady. Despite the growing divergence, which is putting downward pressure on the Canadian dollar, experts say the BoC is more concerned about the looming threat of U.S. tariffs and their potential impact on the Canadian economy.
The BoC’s overnight rate now stands at 3 per cent, following a series of aggressive cuts that began in June 2024, bringing it down from a high of 5 per cent. Meanwhile, the U.S. Federal Reserve maintained its key rate in a range of 4.25 to 4.5 per cent, reflecting the resilience of the U.S. economy in the face of higher rates. This has created a gap of more than one percentage point between the two countries’ interest rates, one of the widest spreads in decades.
The widening rate gap is among the key factors weighing on the Canadian dollar, which has been trading below 70 cents US for over a month. Shelly Kaushik, a senior economist at BMO, noted that the divergence is likely to persist, further pressuring the loonie. “If we do expect this gap to continue or even widen, I think that continues to put downward pressure on the value of the loonie,” she said.
However, Kaushik emphasized that the BoC’s immediate focus is on the potential economic fallout from U.S. tariffs. U.S. President Donald Trump has threatened to impose sweeping tariffs on Canadian goods as early as this weekend, a move economists warn could significantly harm Canada’s economy. Wednesday’s rate cut, Kaushik explained, is an attempt to “create this buffer for the Canadian economy” ahead of potential tariff impacts.
Jules Boudreau, a senior economist at Mackenzie Investments, believes the interest rate gap between Canada and the U.S. is here to stay due to fundamental differences in their economies. “Over the next decade, we’re going to see a one to two per cent spread in the Bank of Canada rate versus the Federal Reserve rate,” he said. “We haven’t seen that over the past few decades, but that’s because the economies were very similar between Canada and the U.S.”
Historically, a one-percentage-point gap between the two countries’ interest rates has been sustainable. However, the current spread is unusual, Kaushik noted, pointing to the last significant divergence between 2003 and 2006, when the Fed raised rates to curb U.S. economic growth amid a real estate boom.
Several factors have contributed to the growing gap between Canadian and U.S. interest rates. Canada’s economy has weakened faster under higher rates due to shorter mortgage terms, higher consumer debt, and slowing population growth. In contrast, the U.S. economy has remained robust, supported by strong consumer spending and fiscal stimulus.
Angelo Kourkafas, a senior investment strategist at Edward Jones, said the BoC is in a challenging position. While a weaker loonie could be inflationary, he does not believe the current divergence is causing significant inflation or disrupting financial markets. “I think there’s no real concerns for now that the divergence is really either creating another wave of inflation or really has impacted financial markets,” he said.
The threat of U.S. tariffs adds another layer of complexity to the BoC’s decision-making. Kaushik explained that while tariffs and potential Canadian retaliation could be inflationary, the overall impact on economic growth would likely outweigh any inflationary pressures. “I do think that would overwhelm any upside inflation impact, at least in the short term,” she said. “So that then does imply that the risk for Bank of Canada policy is for rates to actually go lower, either quicker or even lower than what we currently anticipate.”
As the BoC navigates these challenges, experts agree that the central bank’s focus will remain on mitigating the economic risks posed by U.S. tariffs, even as the interest rate gap with the U.S. continues to widen.