A lot of people assume the Bank of Canada will tag along if and when the U.S. Federal Reserve goes in a new direction.
“There is a 90 per cent correlation between U.S. and Canadian monetary policy, so of course the Bank of Canada will follow,” David Rosenberg, the ubiquitous chief economist at Gluskin Sheff + Associates Inc., a Toronto-based investment firm, told BNNBloomberg earlier this month when asked if a Fed interest-rate cut would be matched by the Bank of Canada.
But the relationship isn’t as automatic as Rosenberg’s comment makes it sound.
Yes, Canadian interest rates track American borrowing costs because the two economies are so entwined. If the U.S. is struggling and in need of monetary stimulus, then chances are Canada will be struggling and in need of monetary stimulus.
And though Canadian policymakers insist their decisions are independent of the Fed, there are limits to how much their policies can diverge. If the gap grows too wide, changes in the exchange rate and bond yields will alter the direction of the economy, forcing a response from policymakers to keep annual inflation at their target of around two per cent.
Still, the Bank of Canada’s room to manoeuvre is much wider than some tend to think.
Sébastien Lavoie, chief economist at Laurentian Bank and a former Bank of Canada staffer, thinks the Fed would have to cut interest rates by more than half a percentage point before Canada’s policymakers would start thinking about matching.
Any assumption that the Bank of Canada will be cutting interest rates in the foreseeable future is based on economic weakness that has yet to show itself in the data, which continue to show that Governor Stephen Poloz and his lieutenants had it about right in April when they predicted growth would rebound from a lousy winter.
The Bank of Canada’s latest quarterly survey of business sentiment published on June 28 shows that executives outside the oil industry were feeling pretty good about the next 12 months. Statistics Canada reported at the same time that gross domestic product increased 0.3 per cent in April from March, a relatively strong reading that pushed Bank of Nova Scotia’s real-time model of second-quarter annualized growth to 2.3 per cent, higher than the central bank forecast in April.
“This latest result can quiet concerns as some analysts call for a rate cut by the bank,” Arlene Kish, director of Canadian economics at IHS Markit, the financial data and advisory firm, said in a note to clients. “We have the bank holding off on any rate changes this year and next.”
It seems likely that the Fed will cut interest rates, but it’s unclear why it will do so. Its chair, Jerome Powell, has expressed concern about the state of the global economy, a worry shared by central bankers in Australia, the European Union and elsewhere. There is no denying that trade wars are impeding trade and putting a chill on investment. The CPB Netherlands Bureau of Economic Policy Analysis reported this week that global trade volumes decreased by 0.7 per cent in April.
But there is a feeling among some analysts that the Fed’s pivot toward stimulus over the past couple of weeks is more about insurance than need. The U.S. economy expanded at an annual rate of 3.1 per cent in the first quarter, an acceleration from 2.2 per cent in the previous quarter, and there is little reason to anticipate a collapse.
Consumption is the primary driver of U.S. growth and consumers are in better shape than they’ve been since before the Great Recession: the labour market is the strongest is decades, household debt is under control and wage growth is showing signs of life.
By indicating it would cut interest rates, the Fed calmed equity markets, offsetting the discomfort caused by President Donald Trump’s latest wave of tariff threats. The Fed also might have raised interest rates higher than it needed to, as inflation remains stuck below its two-per-cent target. As strong as the economy is at the moment, the U.S. central bank could probably get away with letting it run even hotter.
The backdrop in Canada is different. Inflation is around two per cent, right on target. Interest rates in Canada still are stimulative: the benchmark is below inflation, so real borrowing costs are negative. The Bank of Canada and other authorities appear only now to be getting the post-crisis credit binge under control. Poloz and his lieutenants will need convincing evidence that the economy is heading off the rails to undo all that hard work now.
There is no such evidence at the moment.
The GDP report was heavily influenced by increased oil production as Alberta eased its constraints on supply. That positive growth shock won’t be repeated in the months ahead. Still, there is strength in areas that tend to receive less attention than they should.
Kish noted that output by the companies Statistics Canada groups under the heading “computer-assisted design,” a proxy for the technology industry, grew an impressive 0.8 per cent in April. The Business Outlook Survey shows that most executives said sales were growing and that they planned to increase investment over the next 12 months despite the trade wars.
Canada isn’t special. It will be affected by the forces that are bothering central banks elsewhere. But it appears to have some cushion and the Bank of Canada will likely take advantage of it.