Bank of Canada in no rush to match Fed

(July 9, 2004) Despite the recent change of direction at the U.S. Federal Reserve, the Bank of Canada is not likely to follow suit and raise interest rates until its autumn meeting, according to economists at CIBC World Markets.

“Governor Dodge has good reason to drag his feet for a while before dancing to the Fed’s tune,” says Avery Shenfeld, senior economist at CIBC World Markets. He points to the cooling effect a U.S. slowdown would have on Canada, a slowdown which may already be underway.

Shenfeld predicts the Fed will add another 25 basis points at its August meeting. At the same time, Canada’s tame core inflation rate will allow the Bank of Canada to raise rates at a much slower pace.

“The bank will have to limit its rate hikes to less than 100 basis points through 2005, allowing a measured rise in the Fed funds rate to close the gap,” he says. “To show his bona fides as an inflation fighter, Dodge will raise rates a quarter point by autumn. But the Fed’s June rate hike won’t be the last one that the Bank of Canada fails to match over the coming year.”

Aside from low inflation, the bank will want to avoid another rapid run-up in the value of the Canadian dollar. With the U.S. dollar looking increasingly weaker, the bank will need to close the current gap between interest rates in Canada and the U.S., possibly allowing American rates to top Canada’s.

“Canada still faces the adjustment to last year’s record appreciation of the Canadian dollar. Don’t be fooled by the health of exports since then, which captured the cyclical rise in resource prices,” he says. “The drag from a stronger currency takes several years to play out, as sheltering foreign exchange hedges run out, and new plant location decisions are taken in an environment where Canada no longer looks as cheap.”

So far, Fed chair Alan Greenspan has repeatedly indicated he will take a “measured” approach to raising interest rates. Shenfeld sees no reason to doubt him, given the still-fragile nature of the U.S. economic recovery.

“A cooler pace to second half growth, and a capping in core inflation near 2%, should have the Fed gearing down the pace of rate hikes later this year,” says Shenfeld. “It’s not that we will never have a 4% Fed funds rate, but that, as fiscal policy tightens up, it’s going to take a long time to get there.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com