The gap in interest rate policies between Canada and the U.S. widened further as the Bank of Canada cut its key lending rate by a quarter-point on Wednesday, while the U.S. Federal Reserve held rates steady.
Experts say despite the growing divergence, which puts downward pressure on the loonie, the Bank of Canada is more concerned with the impending threat of U.S. tariffs and what they could do to the economy.
The Bank of Canada’s overnight rate is now three per cent, after an aggressive succession of cuts beginning in June last year brought it down from a high of five per cent.
Later on Wednesday, the U.S. Federal Reserve left its key rate unchanged, as the economy south of the border has been more resilient in the face of higher rates.
The Fed cut its rate three times last year, bringing it to a range of 4.25 per cent and 4.5 per cent — more than a full percentage point higher than its Canadian counterpart.
BMO senior economist Shelly Kaushik says she thinks the Bank of Canada will cut twice more this year and that the divergence will widen.
The gap is among the main factors weighing on the Canadian dollar, which has been trading below 70 cents US for more than a month, said Kaushik.
“If we do expect this gap to continue or even widen, I think that continues to put downward pressure on the value of the loonie,” she said.
But right now, the threat of tariffs is more pressing for the Bank of Canada, she said.
U.S. President Donald Trump has threatened to levy sweeping tariffs on Canadian goods as early as Saturday, which economists have warned could deal a big blow to the Canadian economy.
Wednesday’s rate cut is a way for the Bank of Canada to “kind of create this buffer for the Canadian economy,” she said.
Governor Tiff Macklem warned Wednesday that the bank’s options are limited in the face of tariffs.
“What we can do is help the economy adjust. However, with a single instrument — our policy interest rate — we can’t lean against weaker output and higher inflation at the same time,” he said.
Fed chair Jerome Powell said Wednesday that the bank is waiting to see what Trump’s promised policies, including tariffs, will look like before it can assess their impact on inflation and the U.S. economy.
Rate expectations right now see the current spread more or less maintained for the rest of 2025, said TD senior economist James Orlando — but the threat of tariffs has thrown a wrench into that.
“A 25 per cent tariff with retaliation would send the Canadian economy into recession, but it might not send the U.S. economy into recession, and we think that the Bank of Canada would be there to support the economy by cutting interest rates, but we’re not sure that the Fed would do the same thing,” he said.
Mackenzie Investments senior economist Jules Boudreau said he thinks the gap between the two central banks is here to stay due to the two countries’ differing economies.
“If you ask me, over the next decade, we’re going to see a one to two per cent spread in the Bank of Canada rate versus the Federal Reserve rate. We haven’t seen that over the past few decades, but that’s because the economies were very similar between Canada and the U.S.”
According to a TD Economics report from May 2024, the last time a significant gap between the two countries’ interest rates persisted was between 2003 and 2006, when the Fed hiked rates to slow U.S. economic growth amid rising real estate prices.
Historically, a one-percentage-point spread has been sustainable, the report said, noting that in early 1997, the gap between the two rates was 2.5 percentage points.
“It is a bit unusual, for sure, to have this wide of a gap between policy rates,” said Kaushik.
Both the Bank of Canada and the Fed hiked interest rates to deal with inflation coming out of the pandemic, but Kaushik said several factors including shorter mortgage terms and higher consumer debt in Canada meant the domestic economy weakened faster under higher rates.
“We’re clearly more, much more interest rate sensitive here, and that’s requiring us to have this deviation,” said Orlando.
In addition to the effect higher interest rates have had on the economy, Canada faces slowing population growth and a likely decrease in government deficits if the federal Conservatives take power, while the Trump administration is set to spend big, said Boudreau.
“Even before the tariffs, you would have needed to see a gap between the two rates,” he said.
With possible tariffs from the U.S. on the horizon, the Bank of Canada is in a tough spot, said Edward Jones senior investment strategist Angelo Kourkafas.
If the loonie weakens further, it could be inflationary, but “I don’t think we are at extreme levels,” he said.
“I think there’s no real concerns for now that the divergence is really either creating another wave of inflation or really has impacted financial markets,” he said.
Kaushik said it’s tough to predict what will happen with rates beyond this year because of all the uncertainty.
On the one hand, tariffs from the U.S. and retaliation from Canada would be inflationary, but tariffs would also meaningfully hit Canadian economic growth, she said.
“I do think that would overwhelm any upside inflation impact, at least in the short term,” she said, “so that then does imply that the risk for Bank of Canada policy is for rates to actually go lower, either quicker or even lower than what we currently anticipate.”
This report by The Canadian Press was first published Jan. 29, 2025.
