By Paul Vieira
OTTAWA-There is a limit to how much Canadian interest-rate policy can diverge from the Federal Reserve, Bank of Canada Gov. Tiff Macklem said Thursday, as traders ponder how deeply Canada can cut rates without fueling further weakness in its currency.
Macklem testified Thursday before the Canadian legislature's finance committee, less than 24 hours after answering questions from the Canadian senate. He faced myriad questions over the two days about the Bank of Canada's ability to cut interest rates to help a struggling economy, while the Federal Reserve keeps rates at elevated levels due to a setback in slowing inflation.
Economists say a series of Bank of Canada cuts, combined with the Fed on hold, could weigh on the Canadian dollar. A weaker currency would make imports more expensive, as global trade is largely conducted in U.S. dollars, and thereby apply upward pressure on inflation. The Canadian dollar is roughly 4% weaker relative to the U.S. dollar so far in 2024, in part because traders anticipate Bank of Canada rate cuts ahead of the Fed.
"Because we have a flexible exchange rate we can run our own monetary policy, so our interest rates in Canada don't need to be the same as the U.S. rate," Macklem told Canadian lawmakers. "There is a limit to how far they can diverge, [but] we're certainly not close to that limit."
Later, a Conservative Party lawmaker, Marty Morantz, asked Macklem how much weakness in the Canadian dollar he's willing to tolerate. "I'm not going to draw a line in the sand," Macklem said. "Clearly, if we cut interest rates and that weakens the Canadian dollar, that is something you have to take into account."
A Bank of Canada survey of market participants, released last month, indicated traders expect the central bank to start cutting rates in June, and follow up with three more reductions, taking the central bank's benchmark interest to 4% from its current 5% level. The Fed decided Wednesday to maintain its benchmark rate at a range between 5.25% and 5.5%.
As of now, traders in the overnight-index swap market are pricing in just over two rate cuts in Canada for the remainder of the year, said Karl Schamotta, chief market strategist at Corpay, a foreign exchange and global payments company. He said he believes foreign-exchange traders have priced in earlier and more rate cuts from the Bank of Canada, relative to the Fed.
"I don't think investors see any real constraint on the Bank of Canada's capacity to follow a divergent rate trajectory," Schamotta said.
Macklem, in his testimony, said rate reductions, when they begin, would be "pretty gradual." This repeats language in Bank of Canada minutes summarizing the deliberations ahead of its rate-policy decision last month, and has prompted some forecasting firms to scale back their call for the number of rate cuts this year.
Macklem added that higher interest rates in Canada have caused more strain on consumption relative to the U.S., citing the difference in the mortgage market, whereby U.S. homeowners hold 30-year mortgages whereas Canadians need to renew the terms of their home loans every five years. Household debt levels, measured as a share of gross domestic product, are also higher in Canada compared with the U.S.
Economists at National Bank Financial said in a separate report Thursday that a weaker Canadian dollar would push prices for consumer goods higher, but the pass through is likely narrower than expectations. They say research indicates a 10% decline in the Canadian dollar might add 0.30 percentage points to inflation.
National Bank said it's "entirely reasonable that the Bank of Canada's policy rate could fall a full percentage below the Fed's without policymakers batting an eye."
Strategists at TD Securities, however, believe the Bank of Canada can cut rates by a half-percentage point, to 4.5%, without disrupting foreign-exchange markets. "A move below 4.5% will hinge on [Canadian dollar] sensitivity... along with the evolution of domestic economic conditions."
Write to Paul Vieira at paul.vieira@wsj.com
(END) Dow Jones Newswires
05-02-24 1137ET
