The Bank of Canada (BoC) is poised to make its final interest rate decision of 2024, with widespread anticipation of a fifth consecutive rate cut. The central bank’s benchmark rate currently stands at 3.75%, and while a reduction is almost certain, the magnitude remains a point of contention. Financial markets and a growing number of economists are now predicting a more aggressive 50-basis-point cut, mirroring the October reduction, a view bolstered by November’s weaker-than-expected jobs report showing a jump in the unemployment rate to 6.8%. This unexpected surge has prompted institutions like BMO to revise their forecasts, shifting from a more conservative 25-basis-point cut to a half-point reduction. TD Bank remains an outlier, still projecting a quarter-point cut.
The dismal jobs report also sent ripples through the foreign exchange market, contributing to a further decline in the Canadian dollar (CAD), also known as the loonie. The CAD shed approximately half a cent against the US dollar following the report, extending its recent slump. The currency is currently hovering just above four-and-a-half-year lows against its American counterpart, trading around 70.5 cents to the US dollar – a significant drop from its late-September levels. While various factors have been cited for the loonie’s woes, including the re-election of Donald Trump and his protectionist trade stance, the diverging monetary policies of the BoC and the US Federal Reserve are considered the primary driver.
This divergence in monetary policy, with the BoC cutting rates more aggressively than the Fed, is expected to further weigh down the Canadian dollar. The BoC has already implemented 1.25 percentage points of rate cuts since June, placing it among the most proactive central banks globally in easing monetary policy. In contrast, the Federal Reserve, while making an initial half-percentage-point cut in September, has since moderated its pace with a 25-basis-point reduction in October. The contrasting approaches stem from the differing economic landscapes: Canada’s economy has shown more pronounced weakness, necessitating deeper cuts, while the US economy remains relatively robust.
The implications of a weaker loonie are multifaceted. Canadian travelers face higher costs for trips to the US, and domestically, businesses grapple with increased prices for imported goods. Even proponents of a larger rate cut acknowledge the potential risks to the Canadian dollar. A sharp depreciation could quickly translate into higher consumer prices, particularly for groceries, as Canada relies on winter imports of fresh food. This inflationary pressure could undermine the BoC’s efforts to control inflation, creating a difficult cycle to break. The central bank must carefully weigh these factors as it navigates the challenging economic environment.
The BoC faces a delicate balancing act. While the weakening Canadian dollar adds inflationary pressures, the underlying weakness in the Canadian economy necessitates continued monetary stimulus. Recent data, including the soft November jobs report and third-quarter GDP figures that fell short of BoC expectations, reinforce the need for lower rates. While some price stickiness has been observed, the overall economic weakness is expected to exert disinflationary pressure. This context justifies the BoC’s more aggressive stance compared to the Fed. However, the central bank is aware of the limits to this divergence, recognizing the interplay between exchange rates and inflation.
The potential impact of a weaker loonie on inflation is a key consideration. A depreciating currency increases the cost of imported goods, which can feed into broader price increases, counteracting the BoC’s inflation-targeting mandate. While some analysts believe the BoC might refrain from a substantial rate cut due to these concerns, others argue that the overall disinflationary environment, driven by a cooling economy, provides enough leeway to tolerate a modest uptick in import-driven inflation. The majority of consumer spending relates to domestic services, leaving a relatively small proportion exposed to exchange rate fluctuations.
While markets have essentially priced in a 50-basis-point cut, the loonie’s reaction remains uncertain, though a significant further decline is not widely anticipated. However, the market may be underestimating the potential for further divergence between BoC and Fed policies, as the latter is expected to halt its easing cycle sooner given the continued strength of the US economy. This suggests the loonie could experience further depreciation in 2025. Despite the current challenges, the BoC’s proactive approach to rate cuts could lead to an earlier economic recovery in the latter half of 2025, as the lagged effects of monetary easing begin to stimulate consumer and business activity. However, ongoing uncertainties around US trade policy continue to pose a risk to the CAD’s trajectory. Ultimately, a stabilization of the loonie is expected once the BoC reaches its neutral rate and the policy divergence with the Fed narrows.
