Central bank willing to let loonie weaken to tame inflation
The Bank of Canada would be prepared to cut interest rates three times ahead of the Federal Reserve's first rate reduction even if it means further weakening the Canadian dollar, according to analyst estimates.
Investors anticipate the Canadian central bank to start cutting rates in June or July, with today’s inflation reading being a critical factor, Reuters reported.
Meanwhile, the Federal Reserve is expected to hold off on rate cuts until September, despite cooler-than-expected US inflation data released on Wednesday.
Currently, the BoC's benchmark interest rate is at 5%, 38 basis points below the midpoint of the Federal Reserve's policy rate range. Any further widening of this differential could put additional pressure on the Canadian dollar.
However, analysts suggest it would take a significant drop in the currency to impact import costs enough to jeopardize the central bank's goal of reducing inflation to 2%.
"Although there's a theoretical limit to how far the Bank of Canada can set its own policy rate beneath the Fed funds rate, it's likely well below current levels," Corpay chief market strategist Karl Schamotta said in an interview with Reuters. "The exchange rate could weaken if interest differentials were to widen further ... but the passthrough to inflation should be relatively modest."
The Canadian dollar has already depreciated nearly 2.7% against the US dollar this year as the greenback strengthened. While a weaker loonie could increase import costs and inflation, analysts argue the central bank has room to act before this becomes a concern.
"As a rule of thumb, a 10% fall in the loonie would boost core goods prices by 2.5%," said Olivia Cross of Capital Economics, noting that core goods comprise about 30% of the Canadian CPI basket.
Read next: Could rising rates cause a housing and mortgage crisis?
With the Bank of Canada's key rate at 5%, already 38 basis points below the Fed's midpoint, investors anticipate Canadian rate cuts as early as June or July. The April inflation data, due on May 21, will provide crucial input, with forecasts pointing to a year-over-year increase of 2.8%.
The interest rate differential has stayed within 100 basis points since the 2008-09 financial crisis. However, Bank of Canada Governor Tiff Macklem said, "We're certainly not close to that limit," suggesting more room for divergence if Canada's economic outlook deteriorates further.
"A larger-than-expected drag on the household sector from mortgage renewals could give the Bank more license to diverge from the Fed," TD Securities macro strategist Robert Both said.
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