Canada trims interest rates while the U.S. holds firm: Why the split and what’s next?

Americans may be looking north with a hint of envy.

Last week, Canadians saw their first interest rate cut in more than four years, while the Federal Reserve hints that even a single rate cut in the U.S. this year is uncertain.

On Wednesday, the Fed held its rates at 5 to 5.25%, while the Bank of Canada made a 25 basis point cut to 4.75%. This marks a significant policy split that could affect both economies if it continues in this direction.

Allan Small, senior investment advisor at IA Private Wealth, told the Canadian Press that it is' a tale of two economies.’

Bank of Canada governor Tiff Macklem told reporters the bank is confident inflation is nearing 2%. Meanwhile, Fed chair Jerome Powell is more cautious.

He called progress against inflation "modest” and says he’d need more data before moving ahead with a cut.

Macklem acknowledged that Canada could only so much diverge from the U.S. rate policy without paying the price, but that threshold is still far off. “We’re not close to those limits,” he said.

What a policy split could mean for trade

Small points out that if the Bank of Canada’s rate dips too far below the Fed’s, the loonie’s value will likely drop against the United States Dollar.

In response, a strong dollar could reduce demand from the U.S.'s largest trading partner because American goods and services would simply become too expensive for Canadians.

“The Bank of Canada says that they have a lot of room to diverge,” said Small, “At some point, if the U.S. does not start cutting ... it could present some difficulty.”

How big can the split get without a large impact? Brianne Gardner, a senior wealth manager, calls one full percentage point of difference in the interest rate a "comfort zone."

“If there is that window, I would say we're still comfortable with that. If it starts to get a little bit outside that, I think we might reassess,” said Gardner.

What’s the Fed waiting for, anyway?

As for an American rate cut, it’s probably going to be a while.

When the Fed announced it would hold rates, it also said there would likely be just one rate cut in store for 2024. Officials are waiting for more signs that inflation is intently moving downward.

Small says Canada beat us to the punch because its economy is often quicker to respond to interest rate changes. A big reason for that is Canadians typically renew their mortgages every 3-5 years vs. every 30 years.

Canadians who just renewed their mortgages at a higher rate are cutting their consumer spending.

Small also noted that Canada heavily depends on commodities like oil, while technology companies, currently experiencing growth due to artificial intelligence, play a more significant role in U.S. financial markets.

At the beginning of 2024, the Fed projected three rate cuts this year. The Fed walked back those predictions in the spring in part due to continued growth in consumer prices and a strong labor market.

Now, we’re down to one if we’re lucky. Some Fed officials have even said they see the fight against inflation stretching into 2025.