How an aggressive Fed rate cut can scare the market
The U.S. Federal Reserve is widely expected to cut its interest rate Wednesday for the first time in over a decade -- a big step, though one unlikely to pull Canada's central bank out of its holding pattern any time soon.
The Bank of Canada sent signals earlier this month that the Canadian economy is very much on its own path and, at least in the short term, has no reason to follow any move by the Fed to lower rates.
One thing appears certain -- Bank of Canada governor Stephen Poloz and his team will dissect the Fed's explanation behind the decision.
"What's going to matter most to markets, to economists, to global central banks is not what the Fed does on Wednesday -- but why the Fed moves," said Frances Donald, managing director and chief economist for Manulife Investment Management.
When Canadians look south of the border, Donald said, they should care deeply about whether the Fed is cutting rates to deal with weak inflationary pressures or because it predicts the economy is heading into a recession.
"The reason for that is because if the U.S. economy suffers a recession, so too will Canada -- with an approximate six to 12 month lag," Donald said.
"So, governor Poloz will be watching very carefully."
Earlier this month, Fed Chairman Jerome Powell signalled a U.S. rate cut was likely due to slowing global growth and trade wars.
A rate reduction by the Fed would be the first since the Great Recession of 2008. It would come at a time when the U.S. economy is still in decent shape -- unemployment numbers are as low as they've been in decades and American consumer confidence has looked strong.
The U.S. is facing external challenges related to the global economy and trade conflicts. At home, inflation has been running below target and central banks can drop interest rates as a way to lift consumer prices.
Craig Alexander, chief economist for Deloitte, said the expected rate cut should be viewed as "taking out insurance on the economic expansion" and not a sign Powell sees a larger downturn on the way.
"I don't think the economic indicators, at this point, are flashing that a recession is upon us," Alexander said.
He doesn't see any urgency for the Bank of Canada to follow the Fed's lead.
"The two central banks didn't move in lockstep with rates going up, so they don't need to move in lockstep with rates coming down," Alexander said.
"One could argue that the Fed went farther faster and now it's going reverse some of that, so there isn't the pressure on the Bank of Canada to respond."
The Bank of Canada should also be careful about "expending ammunition" that could be used later to deal with a downturn, he said.
Alexander added that a rate cut by the Fed could bring benefits to trade-dependent Canada by bolstering U.S. and foreign demand. It could also put additional upward pressure on the Canadian dollar.
Earlier this month, the Bank of Canada kept its interest rate at 1.75 per cent for a sixth-straight policy meeting. Canadian economic growth has shown signs of re-emerging after it nearly stalled in late 2018 and early 2019.
The bank, however, showed no urgency at the July meeting to make a policy change even though the Fed had already signalled its intention to lower the U.S. rate.
Carolyn Wilkins, the Bank of Canada's senior deputy governor, explained at the time that the U.S. and Canada were at different points in the economic cycle.
"The fact that Canada is picking up while the U.S. economy is slowing sounds like a divergence. In fact, it's a process of convergence," said Wilkins, noting Canada's interest rate was already lower than the Fed's.
"The United States is slowing to a more sustainable pace, while Canada is moving back up to its trend growth... By the second half of this year, growth should be similar in both economies as they converge on their respective potential level of activity."