Could an aggressive US Fed impact Canada interest rates?

The Bank of Canada may be jolted into action if the loonie takes damage

Could an aggressive US Fed impact Canada interest rates?

As the Bank of Canada weighs up whether to keep interest rates at their current level for the rest of the year, it may be casting an anxious glance to its US counterpart’s policy south of the border.

The Canadian central bank’s announcement last week that it was leaving its trendsetting interest rate unchanged arrived amid combative language from Federal Reserve chair Jerome Powell, who set the stage for even larger rate hikes in the US than expected during comments to the Senate Committee on Banking.

Powell told the committee that Fed rate increases were “likely to be higher than previously anticipated” thanks to persistent inflation and a still-robust jobs market, leaving markets reeling and seeing expectations surge of a half-point March hike in the US.

That’s significant for the Canadian economy because a ramping-up of US rhetoric on interest rates, coming at the same time as a pause on Bank of Canada hikes, could potentially cause significant damage to the loonie as the central banks’ policies diverge.

Shortly after the Bank’s Wednesday rate announcement, the Canadian dollar plummeted to its lowest level against the greenback since October, holding near that level at the end of the week.

How the Fed is weighing on the BoC’s thinking

While the Bank’s statement accompanying its March rate call made no reference to monetary policy in the US, the aggressive approach taken by Powell will undoubtedly be a prominent factor in its future decisions, according to BMO’s chief economist.

Doug Porter (pictured top) told Canadian Mortgage Professional that although the central bank rarely mentions the Fed explicitly in its statements, it would certainly be keeping a close eye on interest rate developments there.

“They also made no mention of the Canadian dollar, which if course has been hit by the much more strident tone of the Fed,” he said. “it’s almost like they didn’t want to go there at all.

“But the reality is that does complicate matters somewhat for the Bank. [It] can deviate a bit from the Fed, but there are limits to how far away from US policy the Canadian policy can get without causing some pretty serious damage to the Canadian dollar.”

Has the Bank of Canada done enough on interest rates?

CIBC’s deputy chief economist Benjamin Tal told CMP after the Bank’s decision last week that it could be spurred into further action on rates if the dollar sees significant damage, although it has given itself clear room to make that choice rather than playing catchup.

“I think in retrospect, it seems that the Bank of Canada started to raise interest rates a bit too late – but [it’s] again very difficult to time this kind of situation, given that we were in the middle of COVID,” he said.

“Remember that monetary policy in Canada is more effective than in the US given the amount of debt that we carry relative to the US… The effectiveness of monetary policy means that you don’t need to raise interest rates as high as the Fed.”

One unknown could be the potential impact of the fall of Silicon Valley Bank in the United States, a development that may cause the Fed to abandon its plans for big rate hikes – with the prospect of Bank of Canada rate cuts this year rising, according to markets.

Both Porter and Tal spoke with CMP after the Bank of Canada announcement last week but before Silicon Valley Bank’s collapse was revealed.

On the Bank of Canada’s rate-hiking trajectory of the past year, Porter said it deserved some credit for having raised rates fairly decisively over and arriving at an apparent endpoint sooner than many of its counterparts.

Apart from the Bank of Japan, most major central banks have increased interest rates at each of their decisions during the past year, he said, with the European Central Bank the last to leave its rate untouched in June 2022.

“[The Bank of Canada was] certainly one of the first central banks out of the box and in a pretty serious way, raising interest rates,” he said.

“So not only were they one of the first to hike rates to begin with – they were one of the first to move more than a quarter percent, and they were one of the few to raise by a full 100 basis points at one stage. So definitely, the Bank was relatively quick to get the job done.”

What are your thoughts on how the Bank of Canada’s path on interest rates could be influenced by the US Federal Reserve? What advice are you giving to clients in the current economic climate and how interest rates are likely to play out for the remainder of the year? Let us know in the comments section below.