Why a strong U.S. economy might delay rate cuts in Canada

Tailwinds from south of the border could give a lift to the Canadian economy and end up pushing back the timeline for interest rate cuts as the Bank of Canada tries to keep pace with the United States Federal Reserve, some economists say.

Canada’s economy showed signs of life to end 2023, data released Wednesday suggests. Statistics Canada states real gross domestic product grew through November and December, setting up a rebound for the economy in the fourth quarter after contracting in the third.

With U.S. GDP coming in at 3.3 per cent annualized growth in the fourth quarter, however, the American economy is still outperforming Canada’s early estimates for 1.2 per cent annualized growth in Q4.

Both economies have had their respective central banks rapidly tighten monetary policy to tame inflation, and both have found success to date in cooling inflation. Though neither the Bank of Canada nor the U.S. Fed has seen price pressures hit their two per cent target yet. If the economy is running too hot and threatens that path toward two per cent inflation, interest rates could remain elevated for longer.

The reason the U.S. economy is holding up better under the weight of higher interest rates comes down to the “mighty consumer” in the States continuing to “defy expectations,” says Priscilla Thiagamoorthy, senior economist at BMO.

Canadian households are more vulnerable to shocks from higher interest rates because of their relative debt levels, Thiagamoorthy tells Global News.

While the U.S. consumer largely reduced their debt load in the wake of the 2008-09 financial crisis, Canadians have continued on a “borrowing binge,” she says. Canada’s household debt servicing ratio hit an all-time high of 15.2 per cent in the third quarter of 2023, according to StatCan.

An RBC consumer spending report released Wednesday said that per person spending has declined two per cent since the Bank of Canada started hiking interest rates, with headwinds from record-high financial obligations likely to continue through the first half of 2024.

“Households here are definitely feeling the pinch under the weight of elevated interest rates, and that’s resulting in weaker spending,” Thiagamoorthy says.

Among the pain points ratcheting up the pressure on Canadian debt are looming mortgage renewals. In the U.S., however, the existence of 30-year mortgage terms means some homeowners are more insulated from higher interest rate environments than in Canada where five-year terms are the popular choice.

“There is a much faster transmission of monetary policy into the Canadian economy,” Simon Harvey, head of FX Analysis at Monex Europe and Canada, tells Global News.

While the Bank of Canada is looking for signs in the Canadian economy to give it confidence that demand is waning and inflation will continue to ease, there are already signs of knock-on effects from the strong growth south of the border.

StatCan noted that GDP growth in November was largely attributed to goods-producing industries like manufacturing and wholesale trade, which BMO chief economist Doug Porter said in a note Wednesday was likely boosted by the U.S. economic juggernaut.

“Since these sectors are heavily influenced by exports, it seems that the surprising resiliency in the U.S. economy is indeed spilling over into some sectors in Canada,” he said.

After Wednesday’s GDP release came in stronger than most economists had forecast, markets slashed odds for a Bank of Canada rate cut in April, instead shifting calls for easing to start in June.

While the Fed is also looking for signs of cooling in the economy before it pivots to interest rate cuts, Harvey says that monetary policymakers in the U.S. likely have less to worry about from a robust economy than their Canadian counterparts.

Looking at Canada’s meek economic growth, it’s currently sustained by a population boom and an unravelling of supply constraints, which are short-term in nature and cover up a long-standing trend of declining GDP per capita, Harvey says.

Stripping that away, the Canadian economy is facing a sharper risk of a recession if interest rates remain elevated for longer, he argues.

The U.S., on the other hand, has a longer runway to work with to achieve a soft landing – an economic slowdown that avoids recession. Thiagamoorthy says the Fed is in a “sweet spot” right now with inflation trending down and the economy holding strong, allowing monetary policymakers in the U.S. to be more patient with their shift to rate cuts.

After announcing the Fed’s fourth consecutive rate hold on Wednesday, chair Jerome Powell signalled that while cuts are indeed in the cards for 2024, they’re not imminent, pouring cold water on hopes for a cut in March.

While both central banks are independent in setting monetary policy, Thiagamoorthy says the Bank of Canada will typically move in “lockstep” with the U.S. Fed’s rate path.

“There isn’t a lot of wiggle room between the Bank of Canada and the Federal Reserve,” she says.

However, the Bank of Canada has been breaking historical norms and diverging from the Fed in some of its decisions over the last few years. Asked in late 2023 whether hints of cuts from the U.S. Federal Reserve would prompt similar action from the Bank of Canada, governor Tiff Macklem said he wouldn’t necessarily follow the Americans’ lead.

“The Fed’s going to do what they need to do, we’re going to focus on what needs to be done here in Canada,” Macklem said.

But a lot of what binds the Bank of Canada to its American counterpart is the exchange rate of the Canadian dollar to the U.S. greenback.

Harvey explains that when interest rates are higher in one jurisdiction than another, investors are more likely to park their money there and earn a higher return, driving up the relative value.

Prospective interest rate moves are already priced in by money markets, but if the Bank of Canada were to cut faster than expected in a bid to boost the economy, Harvey says that would likely send the loonie’s value down.

There are two implications there for monetary policymakers: first, it would raise the value of Canadian exports to the U.S., giving a boost to the economy. But it would also make imports more expensive, resulting in “inflation shock” with goods brought in from the U.S., Harvey explains.

Both Thiagamoorthy and Harvey expect that the Bank of Canada will jump first when it comes to rate cuts because of the relative economic weakness north of the border. But even if the Bank of Canada cuts before the U.S. Fed, Harvey says the signposts are clear that the two central banks are still moving in broadly the same direction, which should limit inflationary shocks from a slight difference in timing.

While the Bank of Canada surprised markets early in its interest rate hiking cycle with a 100-basis-point hike in July 2022, Harvey says the foundation was laid for such a move by a shift into a more aggressive tightening posture from the U.S. Fed a month earlier.

Harvey says a similar phenomenon is playing out now with the Fed saying it was considering multiple rate cuts for the year ahead in December, followed by the Bank of Canada removing some references to the need for additional hikes in its January decision.

With monetary policymakers on both sides of the border now cuing the eventual denouement of the tightening campaigns, Harvey says markets shouldn’t be too stressed about an earlier move from the Bank of Canada.

“Fundamentally, both the Bank of Canada and the Federal Reserve are moving in the right direction,” he says.

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