A decision by the U.S. Federal Reserve to resume its policy of creating new money to purchase financial assets has the potential to influence borrowing costs far beyond the United States, including Canada.
Bank of Canada Governor Mark Carney said Friday that if the Fed were to embark on another round of asset purchases, a strategy known as quantitative easing because policy makers seek to reduce interest rates by increasing the money supply, it would factor into whether he would continue lifting Canada's benchmark interest rate, which now sits at 1 per cent.
“There are limits to the divergence that there can be between Canada and the United States,” Mr. Carney said in an interview with the CNBC business television network that was staged at the Museum of Civilization in Gatineau, Que.
The Fed has not yet decided to return to quantitative easing, but its concession this week that it's worried about falling short of its inflation and employment targets without fresh stimulus clouds the outlook for countries in better shape, especially Canada.
Mr. Carney's comment was notable because Canadian central bankers tend to play down any link between the Fed's decisions and their own. The idea is to discourage the notion that the Bank of Canada is a mere copy cat of its American cousin when it comes to setting interest rates. And for the most part that is true: Mr. Carney has increased Canada's benchmark overnight rate three times since June, while the Fed's key borrowing rate remains near zero and U.S. policy makers repeated this week that they intend to leave it there for a considerable amount of time yet.
Canadian and U.S. monetary policy has the appearance of being linked because Canada's economic fortunes are tied so tightly to those of its largest trading partner.
If the U.S. economy is fairing so poorly that the Fed is considering measures to spark growth, then it's only a matter of time before that weakness spills into Canada, which ships more than 70 per cent of its exports to U.S. customers.
“The renewed weakness in the United States, if it prompts quantitative easing or other actions by the Fed that have been discussed, then we deal with the direct consequences,” Mr. Carney said in the interview.
“Obviously, we'll adjust monetary policy to Canadian circumstances.”
Still, Fed policy matters for the Bank of Canada and other central banks because monetary policy is an important driver of foreign-exchange rates.
Countries with higher interest rates present opportunities for quick profit for investors, who borrow in nations with lower rates.
Research shows quantitative easing programs tend to weaken currencies.
So, in the case of Canada, there is significant risk that further interest rate increases while the Fed flushed hundreds of billions of dollars into the financial system would cause investors to flock to the Canadian dollar.
That would hurt exporters, impeding Canada's recovery.
That's why Mr. Carney's decision to part with convention and state clearly that there are limits to how far his policy can diverge from that of the Fed's was likely a gentle reminder to traders that they shouldn't assume he will keep raising interest rates.
Mark Chandler, a fixed-income strategist at RBC Dominion Securities in Toronto, said he thinks the comments show Mr. Carney is “willing to pause if QE goes ahead in the U.S.”
Added Sébastien Lavoie, an economist at Laurentian Bank in Montreal: “Canada can't go too far one way while the U.S. is going the other way.”
