The Bank of Canada and the U.S. Federal Reserve have taken different paths over the past year and a half, with the Fed raising rates more aggressively than its Canadian counterpart.
That period is now over. Interest rates in the two countries are likely to move closer together over the coming months as U.S. growth slows and Canada picks up speed.
Policy-makers in both countries are sounding many of the same notes. The Bank of Canada’s monetary policy statement on Wednesday warned that trade conflicts are taking their toll on global trade. U.S. Federal Reserve chairman Jerome Powell made much the same point in his semi-annual testimony to Congress, also on Wednesday.
To be sure, the near-simultaneous statements on both sides of the border also pointed to the near-term differences between the Canadian and U.S. perspectives. Mr. Powell’s remarks underlined the uncertainties facing the U.S. economy. His testimony strongly supported the case for the quarter-percentage point cut that markets are expecting at the Fed’s meeting at the end of this month.
In contrast, the Bank of Canada left its key rate unchanged and appeared in no rush to cut rates. It predicted a rebound in Canadian growth, from 1.3 per cent this year to 1.9 per cent in 2020 and 2 per cent in 2021 on the back of strong consumer spending, expanding exports and a modest recovery in housing activity.
Regardless of the difference in tone between the two central banks, the end results are likely to be similar from an interest-rate perspective. If futures markets are right, the key Fed funds rate in the United States and the policy rate in Canada are likely to converge by the end of this year, as the Fed cuts rates while the Bank of Canada stands pat.
At the moment, the key U.S. rate stands at 2.5 per cent and its Canadian counterpart at 1.75 per cent. But the futures market sees both the Fed funds rate and the Canadian policy rate hovering around 1.75 per cent by the end of December.
History shows that the two countries have rarely diverged for long on monetary policy. Outside of the late 1980s and early 1990s, when the Bank of Canada maintained significantly higher rates than the U.S., key rates in both countries have typically been similar.
Growth has also tended to follow the same ups and downs on both sides of the border. The past couple of years have been an exception, with a booming U.S. economy outpacing that of its Canadian neighbour.
However, the Bank of Canada expects that discrepancy to soon fade. It says U.S. growth will fall back to 1.7 per cent in 2020 and 1.6 per cent in 2021, slightly below its forecast for Canadian growth.
This pattern would restore the close link between the two countries’ performance. Investors, though, may not want to assume the two countries will always move together. In some ways, their economies are now more different than they have ever been.
One key contrast is in household debt. U.S. consumers substantially reduced their debt loads after the 2008 financial crisis and collapse of the U.S. housing bubble. In contrast, Canadian households continued to borrow with abandon, driving their borrowing to unprecedented highs versus their disposable incomes and propelling home prices higher. Canadians are now spending record portions of their paycheques on debt payments.
Everything being equal, this suggests interest rate shifts are likely to have a greater effect in Canada than in the U.S. If trade tensions grow, and the global economy slows more than expected, the Bank of Canada may have little choice but to join the rate-cutting trend, despite concerns this might fan inflation by reducing the value of the loonie and increasing import prices.
“We continue to expect the Bank to cut interest rates in October,” Stephen Brown, senior Canada economist at Capital Economics, wrote in a note Wednesday. He expects a couple of additional rate cuts to follow.