April 24, 2024, 10:07 AM

A Weaker Canadian Dollar Won't Necessarily Derail Bank of Canada Interest Rate Cuts, Says RBC

The Canadian economy is sharply underperforming its global peers -- particularly the United States -- in the wake of earlier aggressive interest rate hikes, said RBC.

Surging population growth has propped up measures of total economic activity, but that is masking underlying softness when measured on a per-person basis, noted the bank.

Since 2019, Canadian gross domestic product (GDP) per capita has declined 2.8% versus a 7% increase in the US. That marks the largest underperformance of the Canadian economy versus the US over a comparable period since at least 1965. The unemployment rate in Canada has increased by 1.3 percentage points since the summer of 2022 compared with just 0.4 percentage points in the US.

The divergence indicates the Bank of Canada (BoC) should begin cutting interest rates earlier and faster than the US Federal Reserve. RBC looks for a first cut in June compared with the first expected move from the Federal Reserve later in December. The bank anticipate 100bps worth of interest rate cuts from the BoC by the end of this year versus just one 25bps cut from the Fed.

Markets have been cautious about "pricing in" a significant gap in expectations between interest rates set by the Fed and other central banks, but the reality is, historically, monetary policy responses have varied significantly across borders, pointed out the bank. Indeed, that's exactly why independent central banks exist. A floating exchange rate is what enables interest rate policies to diverge across regions and acts as a shock absorber for the economy by increasing net trade.

All else equal, a widening gap in central bank policy rates that RBC expects is more negative for the Canadian dollar (CAD or loonie) than would otherwise be the case. A weaker Canadian dollar will increase the cost of imports at a time when the BoC has been working hard to get inflation under control -- with prices adjusting particularly quickly for products such as gasoline, fresh fruits and vegetables.

But for a large geographically diverse country such as Canada, end consumer prices also depend a lot on the added cost of getting a product on store shelves after it crosses the border and the pricing practices of domestic wholesalers and retailers. Imports from regions other than the US aren't also necessarily impacted by changes in the CAD/USD exchange rate, stated RBC.

A weaker economy makes it more difficult to pass increased import prices to customers and domestic transportation costs have trended persistently lower. The cost of general freight trucking, for example, is running around 6% below year-ago levels.

Canada still trades disproportionately with the US, but when it comes to final consumer goods imports, a relatively larger share (65%) comes from elsewhere. Added to this, the Canadian dollar doesn't look as weak when measured against other currencies. Almost 20% of consumer goods imports and 30% of electronics imports come from China. China's economy has also looked wobbly due to an ongoing pullback in the property market, and the Canadian dollar hasn't depreciated as much against the renminbi, noted the bank.

Broadening the scope of consumption outside of just goods, more than half of overall household spending in Canada is on services. For these services, it's domestic demand and inflation expectations that will set the pace of price growth. Even in the US where inflation concerns have been resurfacing, most of the concerning uptick has come from domestic services rather than tradeable goods.

A softening economy -- which has happened in Canada substantially over the last year and a half -- makes it more difficult for businesses to pass on price increases and stay competitive. The BoC's Business Outlook Survey (BOS) showed that businesses have been raising prices less frequently, while the size of price adjustments has also declined as consumer demand softens. Wage growth has also shown signs of moderating as hiring demand falls (job openings are down more than 25% from a year ago) and the unemployment rate rises.

Commodity price volatility remains a risk for inflation going forward, and oil prices have risen in recent months. But with domestic demand expected to stay soft through much of 2024, and longer-run inflation expectations are still well-anchored in Canada. RBC expected overall inflation pressures will keep receding, and that will drive BoC to cut the overnight rate this year, regardless of actions from the Fed.

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