US and Canada Taking Different Approaches to Interest Rate Policy

Despite the close economic ties between the US and Canada, their central banks are taking different approaches to interest rate policy.  Although typically in lockstep for rate decisions, we are getting very different messages from the Fed and BoC.  

In the US, the Federal Reserve is talking about continuing to increase interest rates until they have beat inflation into submission.  The opposite is true for the Bank of Canada, as they are now worried about overshooting the sweet spot for interest rates and are in danger of grinding the economy to a halt. 

How could that be?  Shouldn’t the Bank of Canada and the US Federal Reserve be in lockstep?  You would think since our economies are tightly woven together that the Bank of Canada would be at the mercy of the powerful Fed and the mammoth US economy when it comes to rate policy.  It turns out that it’s not that simple.   

The word on the street was that the Fed had plans for a .25% interest rate hike at the next two policy meetings before pausing to evaluate.  Federal Reserve chair Jerome Powell said Tuesday that if a strong labour market continues higher interest rates will be necessary.  The 517,000 US jobs added in January are a direct threat to the Federal Reserve’s inflation targets.  That being said, the US employment rate is at a 53-year-low, and quite possibly beyond “maximum employment”.  There’s not a lot of room to squeeze out more jobs.  There’s not a lot of room for the economy to expand further.  A slowdown of the economy with higher unemployment is quite likely and would certainly aid in the Fed’s aim to get inflation back on target.  

Shouldn’t Canada be in a similar situation?  Canada added 104,000 full-time jobs in December, which prompted the Bank of Canada to increase interest rates by .25%.  StatsCan released another report this week, that the Canadian economy added another 150,000 jobs in January!  Earlier this year, Tiff Macklem stated that the hot job market is running counter to the efforts of the Bank of Canada, and that continued wage inflation of 4-5% will force the Bank's hand, and higher rates will be inevitable.  

 A looming factor is that Canadians took on more debt since the housing crisis of 2008, when Americans were deleveraging through that period.  Couple that with the fact that we have much shorter mortgage terms.  Typically Canadians will take on mortgage terms of five years or less.  The US has mortgage terms in the 25 to 30 year range.  Not only do we have more debt per person, but because of shorter mortgage terms, we’re much more susceptible to swings in interest rates since we reset our rates much more frequently. 

The Governor of Canada, Tiff Macklem, is aware of these factors, and knows that overshooting on the policy rate in Canada would be much more dangerous to the health of the economy than it would be if the Federal reserve were to overshoot on their policy rates.  For now the Bank of Canada is on pause, but in my opinion we can not continue to see wage inflation and job numbers like this for too much longer without the Bank of Canada reversing course and hiking rates.  Ultimately, Macklem said it could take up to two years for Canadians to see the full impact of the interest rate increases.

In conclusion, the Federal Reserve and the Bank of Canada have different perspectives on interest rate policy and are taking different approaches to managing the economy. The Federal Reserve's plans to continue raising interest rates are driven by its aim to beat inflation, while the Bank of Canada is concerned about overshooting and stalling the economy. Despite the close economic ties between the US and Canada, each central bank must consider the unique factors affecting their respective countries and the mindsets of the citizens.