A tale of two central banks

Christine Tan, CFA, Portfolio Manager, SLGI Asset Management Inc.

The Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) are moving cautiously towards looser monetary conditions in 2024. But the Fed is doing it from a point of relative economic strength.

Elevated interest rates hit Canada and the U.S. differently

As inflation trends down in the U.S. and Canada, we expect both countries to loosen restrictive monetary policies in the coming quarters.

Over the last two years, both central banks hiked interest rates to fight decades-high inflation; in Canada to 5% and in the U.S. to a range of 5.25%-5.50%. However, the impact of high interest rates has played out quite differently for each over that period.

While the U.S. economy has shown relative resilience in the face of high interest rates, helped in large part by significantly higher levels of government deficit spending (-6.5% of U.S. GDP versus a deficit of -1.4% of Canada’s GDP*), Canada’s economy has relatively underperformed. For 2024, we believe government and consumer spending will have a big influence on economic outcomes.

The Bank of Canada follows the Fed

As expected, the BoC held its policy rate unchanged at 5% at its January meeting. Its softening monetary stance follows a similar move the by the Fed.

In December 2023, the Fed indicated that current rates appear sufficient to help bring down inflation to its target level of 2% over time. The BoC, for its part, said that Canada’s economy has entered a state of “excess supply” meaning that inflation should continue to trend downward.

In plain English, both central banks delivered the same message: interest rates have peaked.

Source: Macrobond, as of January 30, 2024

The two economies and their respective central banks face slightly different economic backdrops. Despite some momentum in Q4 2023 hard and soft economic data in Canada tell a story of an economy that is slowing.

The BoC’s Q4 2023 Business Outlook Survey showed that economic uncertainty, cost pressures, and demand concerns are the top three concerns for Canadian businesses. Canada’s job market is also struggling to keep pace with its growing labour force.

The U.S. economy on the other hand grew a robust 3.1% in 2023, driven by a strong consumer and the high level of government deficit spending.

The path ahead for the BoC and the Fed

As the effect of interest rates play out with a lag, we think both the U.S. and Canada are headed for a slowdown in 2024 but Canada’s economic prospects could face greater headwinds.

One key driver is the higher rate sensitivity of the Canadian consumer. Even though interest rates across the U.S. and Canada rose at the same rapid pace, Canadian consumers felt the burden of debt more intensely. Canadian mortgages typically have a tenure of five years or less, which means more Canadians have been, or are, facing mortgage resets at significantly higher rates. Conversely, U.S. mortgages are often fixed for 30 years. This has led to Canadian consumers spending an increasingly higher share of their income servicing debt. The BoC Q4 2023 Consumer Expectations Survey showed that 69% of consumers surveyed are reducing their spending due to their expectations of higher interest rates and lower future wage growth. Conversely, U.S. consumers are less impacted and can maintain discretionary spending, albeit at a slower pace.

Reduced consumer spending, a weakening business outlook and the resulting downward pressure on prices is why we think the BoC is readying itself to cut rates, possibly in late Q2. On the other hand, the Fed, which has a dual mandate to achieve maximum employment and keep prices stable, might be slower to ease as the economy remains resilient.

We will be closely watching the upcoming data in the U.S. and Canada to get a read on each country’s economic trajectory. For now, the outlook looks brighter south of the border as long mortgage tenures and high government deficit spending buffers the impact of higher interest rates. 

* Source: Bloomberg, Statistics Canada October 2023

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