The Federal Reserve has just given the Bank of Canada an awful lot to think about.
On Wednesday, the U.S. central bank did a lot more than raise its policy interest rate by another three-quarters of a percentage point, to a range of 3 per cent to 3.25 per cent, a 14-year high. It raised the stakes in the global battle against inflation. It set the bar much higher for the peak of interest rates. It placed the world’s biggest economy on the edge of recession as it pursues this steeper rate path.
Now Canada’s central bank – facing different conditions than the Fed, but in pursuit of the same inflation-vanquishing goal – will have to decide what the strikingly altered picture painted by its U.S. counterpart means for Canadian monetary policy. In trying to strike the right balance in interest rates that will put inflation back in its cage without derailing the Canadian economy, the Bank of Canada now must consider how the Fed’s new stance changes that balance – and how much it can afford to diverge its own policy from that of its huge neighbour.
The members of the Federal Open Market Committee – the body that sets rates – projected that the benchmark rate will need to rise by at least another full percentage point by the end of this year, and will likely peak at somewhere between 4.5 per cent and 5 per cent next year. That’s nearly one percentage point higher than the Fed was talking about in the summer – a striking leap in expectations in the space of a couple of months.
The FOMC members also slashed their forecast for U.S. economic growth to a puny 0.2 per cent this year and 1.2 per cent next year, down from July’s projection of 1.7 per cent in both years. Such an anemic growth pace suggests a U.S. economy one sneeze away from full-on contraction. The committee sees unemployment rising next year to mildly above the estimated long-term normal level.
It all implies that the Fed is braced to put the U.S. economy into a stall, teetering on the precipice of recession, in order to tame inflation – a stance that Fed chair Jerome Powell confirmed Wednesday.
“No one knows whether this process will lead to a recession, or if so, how significant that recession would be,” Mr. Powell said in his post-announcement news conference.
“The chances of a soft landing are likely to diminish to the extent that [interest rate] policy needs to be more restrictive, or restrictive for longer. Nonetheless, we’re committed to getting inflation back down to 2 per cent.”
The Fed’s course correction follows an August inflation report that showed alarming increases in core measures of inflation – even after already substantial rate increases this year, as well as evidence that the U.S. economy has already slowed. The apparent stubbornness of inflation has caused the Fed to toughen its talk, and back it up with a considerably steeper path and higher peak for rates.
The Bank of Canada, which has also been raising its policy rate aggressively and had already raised its rate to 3.25 per cent earlier this month, is facing somewhat different conditions. Canada’s inflation rate is more than a full percentage point below that of the United States, and both Canada’s overall inflation rate and core measures fell more than expected last month. Canadian inflation was never as high as that of the U.S., its economic growth during the COVID-19 recovery has been generally less robust, and its central bank began tightening policy earlier than the Fed did.
Most forecasters have assumed that the Bank of Canada’s key rate would peak at 4 per cent at the most. Many believe that the bank is poised to slow the pace of rate increases as soon as its next policy decision in late October, and could put its rate hikes on hold by early next year.
The Fed’s aggressive tack will require some soul-searching in the corridors of the Bank of Canada. The conditions surrounding its rate-hiking cycle have changed.
Obviously, a stalling or even recessionary U.S. economy would weigh heavily on Canada’s own economic outlook, which still looked relatively healthy when the central bank updated its projections in July. If the Fed is determined to engineer a deeper slowdown, we can expect the Bank of Canada will have little choice but to become more pessimistic in its next forecast update in October.
The potential for a large gap between U.S. and Canadian interest rates by next year, and perhaps even a policy diversion should the Bank of Canada go on hold while the Fed is still raising, also poses a serious complication. A higher Fed ceiling for rates will certainly draw more investors to the U.S. dollar, to the detriment of other currencies, including the Canadian dollar. The Bank of Canada will now have to consider a substantially weaker currency – which would on the one hand contribute to inflation by making imported goods from the U.S. more costly, but on the other hand would aid Canadian exports by making them cheaper for U.S. buyers.
How all of this will colour the Bank of Canada’s decision-making is hard to predict. How far the Canadian central bank can comfortably diverge from its big U.S. neighbour in this remarkably aggressive rate cycle is near impossible to judge.
But it’s safe to say that the Fed just made the Bank of Canada’s job harder.
Editor’s note: The range on the Fed’s policy interest rate has been corrected in the online version of this story.