By 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 a falling currency threatens to jeopardize the inflation outlook, the average estimate of seven analysts showed in a straw poll.
A weaker Canadian dollar against the greenback this year has sparked debate among investors about the extent to which the BoC might be willing to diverge from its U.S. counterpart.
Investors expect the Canadian central bank to start cutting interest rates in June or July, with next Tuesday’s inflation figures seen as a key input. But the Fed remains on hold until September, even after U.S. inflation data turned out cooler than expected on Wednesday.
At 5%, the BoC’s benchmark interest rate is already 38 basis points below the midpoint of the Fed’s policy rate range. A further widening of the difference would put pressure on the .
Still, analysts say it would take a big move in the currency to push up import costs enough to jeopardize the central bank’s efforts to bring inflation back to a 2% target.
Higher costs of imported goods tend to increase the prices companies charge consumers.
“While there is a theoretical limit to the extent to which the Bank of Canada can set its own policy rate below the fed funds rate, it is likely well below current levels,” said Karl Schamotta, chief market strategist at Corpay.
“The exchange rate could weaken if interest rate differentials widen further… but its pass-through to inflation should be relatively modest.”
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The latest data shows inflation at an annualized rate of 2.9% in March, down from a peak of 8.1% in June 2022.
The Canadian dollar has already weakened nearly 3% against its U.S. counterpart since the start of the year, to 1.3640 per U.S. dollar, or 73.31 U.S. cents, while the greenback rose against a basket of major currencies.
“As a rule of thumb, a 10% decline in the loonie would increase core commodity prices by 2.5%,” Olivia Cross, North American economist at Capital Economics, said in a note, adding that core commodities account for about 30% of the constitute total production. Canadian CPI basket.
There is a limit to how much U.S. and Canadian interest rates can diverge, but “we are certainly nowhere near that limit,” Bank of Canada Governor Tiff Macklem said earlier this month.
The Canadian economy has lagged the U.S. economy in recent quarters, pressured by weaker productivity growth, higher household debt and a shorter mortgage cycle, a factor that some economists say should lead to the BoC gaining an edge over the Fed.
The OECD expects the Canadian economy to grow 1% this year, far less than the 2.6% it expects for the United States.
The interest rate differential has remained within 100 basis points since the 2008-2009 global financial crisis. Still, that level could not be a binding constraint if Canada’s outlook deteriorates in the second half of 2024, said Robert Both, senior macro strategist at TD Securities.
“A larger-than-expected drag on the household sector due to mortgage extensions could give the Bank more permission to deviate from the Fed,” Both said.
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