The American and Canadian economies usually move in lock step, and generally so does policy. That’s changing, as the US continues to show robust growth despite higher rates, while Canada’s economy won’t budge. As a result, many believe the Bank of Canada (BoC) may have to make what’s thought to be an unusual move—diverge from the US Federal Reserve. BMO Capital Markets took a look at the historical context this morning, and found the central banks heading in two different paths isn’t actually that unusual. Whether or not they should at this time? That’s another story.
Canada’s Economy Is Diverging From The US, Should BoC Policy?
The Canadian and American economy are on diverging paths. US real GDP growth is still astronomical, rising 4.9% at its latest reading. In contrast, Canada’s real GDP growth is flat—even with the massive population boosting aggregate performance. On a per capita basis, the gap widens even further.
What Drives A Rate Gap Between Canada and the US?
Source: BMO Capital Markets.
That presents a problem. The US economy is still growing rapidly and in need of higher rates to moderate inflation. Canada on the other hand, has an economy based largely around real estate. It may need to ease, or at the very least, fail to keep up with the Fed. Is that possible?
“Of course the Bank can diverge from the Fed, if need be,” explains BMO Chief Economist Douglas Porter.
Adding, “There is plenty of historical precedent for such a separation. And a diverging economy is typically the driver.”
Bank of Canada Diverging From The Fed Has Happened… A Lot
The bank’s research shows employment has served as a leading indicator of past divergence. A “normal” unemployment gap is -1 point, which Porter explains is due largely to differences in methodology.
Source: BMO Capital Markets.
“Sure enough, a -1 ppt gap is consistent with overnight rates being in sync, as per the chart,” he highlights.
“The question, however, is whether the Bank will choose to diverge, given its ongoing concerns about sticky core inflation, and a soggy loonie.’
Bank of Canada Is Unlikely To Diverge Due To Inflation
It’s important to remember Canada’s central bank has a single mandate—inflation control. A stable currency is one of the key features of Canada’s economy. It helps to attract investment, employment, and trade. Since inflation impacts all currency holders, the damage is much more widespread than a period of tempered growth. The BoC is unlikely to risk Canada’s long-term viability for a shot at short-term growth.
Canada easing while the Fed maintains, or even increases rates, will result in a weaker loonie. Commodities such as oil, lumber, and even food staples (e.g. corn, wheat, etc.) are priced in US dollars. As a consequence, erosion of the loonie against the greenback is inflationary.
BMO highlighted the possibility of diverging, but they ultimately don’t see it happening. “We doubt there will be a big divergence in policy in the year ahead, although the risks lean to the Bank pivoting to a looser stance earlier than the Fed,” says Porter.