Economists warn that if the Fed can't lower rates, the Bank of Canada may have to delay its own cuts
Higher-than-expected inflation in the US is fuelling concerns that the Federal Reserve may not only delay rate cuts but could even raise interest rates – a scenario that could have ripple effects for the Bank of Canada and Canadian mortgage rates.
The latest Consumer Price Index (CPI) report from the US Labor Bureau revealed that headline inflation rose 3.0% year-over-year in January, exceeding analysts’ expectations of 2.9%. This marks the fourth consecutive monthly increase since inflation hit 2.4% in September, indicating that price pressures are proving stickier than many had anticipated.
For the Federal Reserve, the hotter-than-expected inflation print raises serious questions about its next policy moves. Markets have already slashed their expectations for rate cuts in 2025, now anticipating only one, down from previous forecasts of multiple reductions. But with inflation refusing to cool, some economists warn that the risk of a Fed rate hike is now rising.
"Bad news" for BoC
The prospect of higher-for-longer US interest rates is particularly concerning for Canada, as the Bank of Canada’s ability to cut rates may be constrained by Fed policy.
“Stronger price pressures stateside could also be bad news for Canada if the Fed isn’t able to lower rates this year since it could, at the margin, restrain the Bank of Canada’s ability to cut rates as much as it might have otherwise,” Royce Mendes, managing director and head of macro strategy at Desjardins Group, told Financial Post.
While the Bank of Canada has insisted it has room to set its own monetary policy, Mendes cautioned that there are limits to how much divergence the two central banks can sustain. The Canadian dollar could weaken further against the US dollar, making imports more expensive and pushing up inflation in Canada.
Fed rate hike risks growing
Some economists believe the latest inflation data could force the Federal Reserve to hold rates steady for much longer, or even hike rates again.
“Not much to like in today’s January CPI report,” said Scott Anderson, chief US economist at Bank of Montreal. “The moderation we saw in consumer inflation last summer is no longer visible now.”
Anderson pointed out that core inflation, which excludes food and energy, rose to 3.8% on a three-month annualized basis, while super-core inflation, which measures services costs minus energy and shelter, climbed to 5.3% - both well above the Fed’s 2% target.
Fed chair Jerome Powell, speaking to lawmakers this week, reinforced the idea that the central bank is in no hurry to cut rates. He emphasized that policymakers need to see clearer evidence that inflation is under control before making any moves.
For Anderson, the trend suggests that markets should not rule out the possibility of a Fed rate hike in the coming months, even if the odds remain low.
Impact on Canadian borrowers
For Canadian mortgage holders and homebuyers, the risk of persistently high US rates spilling into Canadian borrowing costs is a growing concern.
“A Fed rate hike or two would likely lead to slower US consumer and business demand and a wider interest rate differential with Canada,” Anderson explained. “This would weigh even further on Canada’s export and job growth, which are already being threatened by higher US import tariffs, and add to weakness in the Canadian dollar.”
Meanwhile, David Rosenberg, founder of Rosenberg Research & Associates, pointed out that inflation is showing up across multiple sectors in the US, making it more difficult to dismiss the rising price pressures as temporary.
“Bond and stock markets will not like this number one bit, and neither will the Fed – with the hawks having the upper hand,” Rosenberg said.
He warned that US inflationary pressures could directly impact Canadian mortgage rates, since Canadian fixed-rate mortgages are largely priced off Government of Canada bond yields, which are heavily influenced by US bond movements.
“US inflation is bad for Canada because the resulting run-up in market interest rates has this nasty habit of seeping into the Canadian fixed-income space, given the 90% correlation between the two countries,” Rosenberg noted. “This ends up tightening domestic financial conditions and blunting the impact of the easing efforts out of the Bank of Canada.”
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The latest inflation surprise has led some analysts to question whether the Fed will cut rates at all this year.
“Inflation… clearly isn’t coming down decisively any more,” said Paul Ashworth, chief North America economist at Capital Economics.
Ashworth pointed out that tariff threats from US President Donald Trump could push inflation even higher, forcing the Fed to maintain its restrictive stance for longer than expected.
With the personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, expected to remain above target, Ashworth believes that the central bank could keep rates on hold for all of 2025.
“The upshot is that markets are now only pricing in one 25-basis-point rate cut by the Fed this year,” he said. “We still think that’s too dovish, and that cuts are off the table for 2025.”
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