Experts discuss how much divergence the Canadian dollar can handle
The Bank of Canada's recent interest rate cut puts it on a different path than the US Federal Reserve, raising questions about the future of the Canadian dollar.
Canada's central bank cut its key lending rate by 0.25% last week, citing confidence that inflation is heading towards its target of 2%. The US, on the other hand, held its rate steady, focused on controlling inflation that remains above its target.
Financial experts warned this diverging monetary policy could lead to volatility for the loonie down the road.
Allan Small, a senior investment advisor, explained that a widening gap between Canadian and US rates could make American imports more expensive and put upward pressure on Canadian inflation.
“If the Bank of Canada cuts a few times and the Fed stands pat, I don't think that will be an issue,” Small told The Canadian Press.
However, if the BoC keeps reducing while the Fed maintains its benchmark rate, especially beyond the first quarter of next year, “we could see significant divergence impacting the loonie,” Small said.
The economies are facing different circumstances, with the US proving more resilient amid higher rates.
"We'll need to see more good data to bolster our confidence that inflation is moving sustainably toward two percent," said Fed chair Jerome Powell.
Read next: Canadian consumer confidence reaches two-year high post-rate cut
In Canada, BoC governor Tiff Macklem said the bank has "more confidence that inflation is heading toward its two per cent target." He acknowledged limits on policy divergence but said, "we're not close to those limits."
Brianne Gardner of Raymond James notes Canada's economy is more rate-sensitive due to shorter mortgage terms. "It's really a tale of two economies," said Small, citing Canada's commodity exposure versus the US tech sector's strength.
Historically, a 100-basis-point rate differential has been a "comfort zone." Gardner said, "I think there's more room for divergence than most people think," pointing to a 250-basis point gap in the 1990s when energy prices buoyed the loonie.
While markets once priced in six Fed rate cuts in 2024, new projections show just one is expected. Powell said the Fed welcomes easing inflation but wants "more good data."
Macklem said further BoC cuts are "reasonable to expect" if inflation continues easing. But Small cautioned, "At some point, if the US does not start cutting...it could present some difficulty, for sure."
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