Interest rate peak

The Bank of Canada’s approach to monetary policy this year should be driven by domestic economic conditions, not the actions of the U.S. Federal Reserve Board or worries about the value of the Canadian dollar, says a report from Royal Bank of Canada’s (RBC) economists.

While the surprisingly strong U.S. economy has pushed back expectations for U.S. rate cuts, weaker results in Canada continue to point to the need for easier monetary policy sooner rather than later, the report suggested.

Some of Canada’s economic weakness has been masked by its strong population growth, but on a per-capita basis, Canadian GDP is down by 2.8% since 2019, RBC said, compared with a 7% increase over the same period for the U.S.

“That marks the largest underperformance of the Canadian economy versus the U.S. over a comparable period since at least 1965,” it noted.

At the same time, the Canadian unemployment rate has also risen by 1.3 percentage points since the summer of 2022, versus an increase in the jobless rate of just 0.4 percentage points for the U.S., it said.

“A sharply underperforming Canadian economy argues for more urgency to start moving interest rates lower than in other countries,” the report said, adding that RBC economists expect the Bank of Canada to cut interest rates sooner, and more, than the Fed does this year.

Indeed, it expects the Bank of Canada to deliver its first rate cut in June, and to drop rates by 100 basis points this year in total.

By contrast, it’s now forecasting just one 25 bps rate cut from the Fed this year, with that not coming until December.

This monetary policy divergence is likely to lead to a weaker Canadian dollar, the report noted, which will boost the cost of imports “at a time when the central bank has been working hard to get inflation under control.”

However, the prospect of a weaker loonie shouldn’t discourage the Bank of Canada from cutting rates, it said.

Historically, shifting exchange rates haven’t had a big impact on inflation, it said. For one thing, over half of Canadian consumer spending is on services. Moreover, imported goods come from a number of countries, not just the U.S., it said — and, consumer prices are also heavily influenced by domestic transportation costs, which are falling.

“A softening economy — which has happened in Canada substantially over the last year and a half — makes it more difficult for businesses to pass on price increases and stay competitive,” it added.

Amid weaker domestic demand, “We expect overall inflation pressures will keep receding, and that will drive Bank of Canada to cut the overnight rate this year, regardless of actions from the Fed,” it said.