Canadian dollar weakness fails to contain Bank of Canada divergence from Fed From Reuters

Fergal Smith

TORONTO (Reuters) – The Bank of Canada would be willing to cut interest rates three times ahead of the Federal Reserve’s first move before currency weakness threatens inflation, the average estimate of seven analysts in a preliminary survey showed.

The Canadian dollar’s weakening against the U.S. dollar this year has sparked debate among investors over how far the Bank of Canada will be willing to diverge from its U.S. counterpart.

Investors expect the Canadian central bank to begin cutting rates in June or July, with next Tuesday’s inflation figure seen as a key factor. But the Fed looks set to remain on hold until September, even after cooler-than-expected U.S. inflation data was released on Wednesday.

The Bank of Canada’s benchmark interest rate of 5% is already 38 basis points below the midpoint of the range the Fed has set for its interest rate. Further widening of the differential could increase pressure on the index.

However, analysts say it would take a significant change in the currency to raise the cost of imports enough to jeopardize the central bank’s efforts to bring inflation down to its 2% target.

The higher cost of imported goods tends to increase the prices that businesses charge consumers.

“While there is a theoretical limit to how far the Bank of Canada can set its own interest rate below the Fed funds rate, it is likely well below current levels,” said Carl Sciamotta, chief market strategist at Corpay.

“The exchange rate may weaken if interest rate differentials widen further… but the effect of inflation should be relatively modest.”

The latest data shows the annual inflation rate was 2.9% in March, down from a peak of 8.1% in June 2022.

The Canadian dollar has already weakened nearly 3% against its US counterpart year-to-date to 1.3640 per US dollar, or 73.31 US cents, as the greenback rose against a basket of major currencies.

“Typically, a 10% drop in the Canadian dollar would lead to a 2.5% increase in the price of staples,” Olivia Cross, North American economist at Capital Economics, said in a note, adding that staples account for about 30% of the Canadian dollar’s value. Canada CPI basket.

There is a limit to how far interest rates in the U.S. and Canada can differ, but “we’re certainly not close to that limit,” Bank of Canada Governor Tiff Macklem said earlier this month.

The Canadian economy has lagged the U.S. economy in recent quarters due to weaker productivity growth, as well as higher household debt levels and a shorter mortgage cycle, which some economists say should lead the Bank of Canada to outpace the Fed.

The OECD projects Canada’s economy will grow 1% this year, much less than the 2.6% growth rate it projects for the United States.

The interest rate gap has remained within 100 basis points since the 2008-09 global financial crisis. However, that level may not be a necessary constraint if Canada’s outlook worsens in the second half of 2024, said Robert Both, senior macro strategist at TD Securities.

“The larger-than-expected impact on the household sector from the mortgage extension could give the Bank more authority to move away from the Fed,” Bot said.