A weakened Canadian dollar runs the risk of raising inflation and incoming U.S. president Donald Trump's ire who wants Canada to buy more American exports.JONATHAN HAYWARD/The Canadian Press
John Rapley is an author and academic who divides his time among London, Johannesburg and Ottawa. His books include Why Empires Fall (Yale University Press, 2023) and Twilight of the Money Gods (Simon and Schuster, 2017).
The central bank recently made a policy announcement that could have significant implications for where Canada’s economy goes next year. The problem is, it wasn’t Canada’s central bank that made it.
After the decision to cut interest rates this month, chair Jerome Powell said the U.S. Federal Reserve could henceforth be “more cautious in reducing rates,” projecting higher inflation and therefore interest rates next year than previously expected.
It’s been a while in coming. Maintaining that it now has inflation under control, the Fed has been cutting short-term rates. But bond investors, judging that the Fed has jumped the gun and inflation will return and affect the fiscal health of the U.S. government, have been selling bonds. That has the effect of driving up long-term rates. One side or the other had to cave. With this move, the Fed has taken heed of what markets have been saying.
The Fed’s move also revealed it is starting to look ahead, and considering the possible inflationary effect of the Trump administration’s proposed policies.
This pivot will have a profound impact on Canada. It occurs at a delicate point. Outside of the U.S., the recovery of the world’s major economies is going slowly. Moreover, the situation is unlike in 2020, when the world’s major central banks co-ordinated their policy loosening. China, Europe and Canada are easing, the latter quite aggressively. But the U.S., Britain and Australia are all moving toward a watch-and-see stand, and Japan has already started raising interest rates.
In a world of open capital markets, where investors can move money freely around the globe at the push of a button, these policy differences can complicate the efforts of central banks to manage their own economies. If interest rates are rising elsewhere, investors can unload their domestic bonds and move their money abroad to seek better returns. This has the effect of weakening their own country’s currency while driving up its long-term interest rates.
Few countries feel this more acutely than Canada. Since the Bank of Canada became the first G7 central bank to cut interest rates in June, it has reduced its target rate by nearly two percentage points, to 3.25 per cent. But in that time, the yield on a 10-year Canadian government bond has barely budged, and is now following the U.S. rate upward. Despite that, given that American bonds still yield over a percentage point more than Canadian ones, investor money has been flowing south, putting downward pressure on the Canadian dollar.
This could cause all manner of headaches for both the government and the Bank of Canada. A weakened dollar runs the risk of raising inflation, given the scale of U.S. imports to the Canadian economy. But more immediately, it will stir the incoming U.S. president’s ire at a time when he’s already peeved at Canada. Donald Trump wants Canada to buy more American stuff, but this move will both make that harder for Canadians while encouraging Americans to buy more from Canada, where prices are lower.
Meanwhile, rising interest rates could crimp the economic recovery. We see this already in the housing market, which started to show renewed signs of buoyancy when the Bank of Canada started cutting rates, but has since slowed back down.
Currently, most analysts are forecasting modest growth in the Canadian economy for next year, landing somewhere in the 1- to 2-per-cent range. However, these forecasts are premised on the assumption that the Trump administration will maintain a fiscal expansion, with tax cuts providing further fuel to the economy. But it now looks like the Fed may be girding for a battle with the administration, with some governors hinting that they’re beginning to factor the inflationary impact of his policies into their own projections. If they decide to counterbalance a loose fiscal policy with a tight monetary one, the economic prognosis may well change.
Should that happen, you can be sure Mr. Trump will join a long list of politicians who’ve railed against their central banks for opposing economic growth. But it will also pose dilemmas for the Bank of Canada over how to maintain its own loosening amid a tightening south of the border.
And for the Canadian government, it will almost certainly create a new challenge – how to mollify Mr. Trump amid a further weakening of the loonie.