Fed’s Hawkishness Casts Doubt on Bank of Canada’s Soft Landing
The United States Federal Reserve’s efforts to combat inflation by raising interest rates have raised questions about the potential impact on the Canadian economy. The Bank of Canada, which has been following a similar monetary policy path as its US counterpart, may face challenges in achieving its goal of a "soft landing" – a period of economic growth with low inflation.
Historical Context
When Bank of Canada interest rates have fallen below those at the Fed, it has typically not coincided with a relatively stronger Canadian growth picture. This suggests that markets may be underestimating how high Bank of Canada Governor Macklem will have to go in raising interest rates or overestimating Canada’s capacity to grow.
Underlying Price Pressures
One possible explanation for the difference in inflation data between the US and Canada is that underlying price pressures in the US are running deeper, perhaps due to a tighter labor market. In contrast, Canada has been ramping up immigration, which could help ease pressure on wages and potentially give it more scope for non-inflationary growth.
Bank of Canada’s Approach
The Bank of Canada may also be more reluctant to jack up borrowing costs given higher household debt levels in the country. However, this argument suggests underlying economic weakness rather than the outperformance many analysts expect.
Linkages between US and Canadian Economies
While Canada can occasionally take a different policy stance than its southern neighbor, there are limits to this divergence – in part because Canada’s economy is so closely linked to the US. Few economists are willing to project any major divergence of inflation between the two countries over the next couple of years.
Immigration and Productivity Concerns
Canada’s immigration policies create their own inflationary problems in the short-term, especially in housing. Additionally, Canada’s weak productivity numbers give economists little confidence that potential growth will far exceed that in the US.
Canadian Economy Performance
So far, the Bank of Canada has moved in lockstep with the Fed through the first half of this year. However, it’s not uncommon for short-term borrowing costs in the US to diverge higher for a spell of time. In fact, there have been four times since the mid-1990s that US rates have outstripped Canadian rates over a multi-year period – often coinciding with times of global economic stress.
Implications
The Bank of Canada’s ability to achieve its goal of a soft landing may be impacted by the Fed’s hawkish stance. While some analysts believe that the Canadian economy is better positioned to withstand higher interest rates, others argue that underlying price pressures in the US are running deeper and could lead to higher inflation.
Conclusion
The Bank of Canada’s monetary policy decisions will have significant implications for the Canadian economy. As the central bank navigates the challenges posed by a strong US dollar and rising commodity prices, it must also balance its desire to achieve a soft landing with the need to address underlying economic weaknesses.
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