Leader of the Pack

Measured by both the size of its balance sheet and the jurisdiction its policy covers, the Bank of Canada is the smallest of the G7’s central banks. But that doesn’t mean Canadian policymakers are destined to be followers. Officials must do what’s best for the domestic economy, a responsibility that will likely result in a rate cut on June 5.

High household debt ratios and five-year mortgage terms mean that Canada’s economy has been hit much harder by rate hikes than its southern neighbour. Smaller debt loads and thirty-year mortgage terms have insulated the US economy from the impacts of the Fed’s rate hiking cycle.

The weakening economic backdrop has, however, helped to normalize price pressures in Canada. Total inflation now stands at 2.7%, the lowest level since March 2021. The Bank of Canada’s preferred measures of core inflation have also fallen back into the 1% to 3% target range and are expected to decelerate further in the months to come. But maybe the clearest sign that conditions are normalizing is that businesses are no longer frequently raising prices (graph), a sign that supply of and demand for their wares are in better balance.

The combination of soft price pressures and a weakening economy means that Canadian central bankers not only have an opening to lower interest rates, but a responsibility to ease the pain on Canadian businesses and households. The question is whether the Bank of Canada is willing to be the leader of the pack when it comes to rate cuts.

It’s often believed that Canadian policymakers can’t lead their US counterparts by too much because of the resultant impacts on the exchange rate. But our recent research External link. has shown that interest rates tend to be of less importance to the Canadian dollar than factors such as risk sentiment, oil prices and broad US dollar moves. Moreover, it takes a very large exchange rate depreciation to push total inflation noticeably higher. But even then central bankers tend to look through such exchange rate pass-through, viewing it as a one-time level shift in prices.

As a result, the Bank of Canada should have no qualms cutting rates with the Fed still on the sidelines. Canadian policymakers are likely to be joined by their European counterparts later in the month, as the ECB is also expected to embark on a rate cutting cycle in the near future. Markets also anticipate that the Bank of England will need to cut rates before the Fed.

The US will therefore stand out as an outlier. With a resilient economy and stickier inflationary pressures, American central bankers must proceed more cautiously. So just as Canadian policymakers’ decision to cut rates will come as a result of local conditions, US officials will need to hold rates higher for longer because that’s what’s best to achieve their dual mandate of price stability and maximum sustainable employment.