Insightful Analysis: Why Bank of Canada’s Decision to Diverge from Fed’s Interest Rate Hike Is Justified
Opinion: The Bank of Canada is right not to follow the Fed’s higher
Bank of Canada governor Tiff Macklem and the bank’s Governing Council recently announced that they would hold their target for the overnight rate at 4.5 percent, despite a hawkish announcement from the US Federal Reserve. While some argue that Canada should follow the Fed’s lead, the Bank of Canada is making the right decision. In this article, we will explore our reasoning behind this belief.
Exchange Rates are not the Only Factor.
Some argue that the Canada-US exchange rate is the main factor determining whether the Bank of Canada should follow the Fed. They suggest that the depreciation of the Canadian dollar in comparison to the US dollar due to the Fed’s policies should prompt the Bank of Canada to follow suit with interest rate hikes. However, this argument fails to consider other factors that determine exchange rates.
Exchange rates should be influenced by monetary policy and external economic factors such as global rebalancing. For example, if the Canada-US exchange rate falls because of a change in investor sentiment, rates should not rise as a reaction. Instead, the exchange rate should act as a shock absorber, and monetary policies should not be impacted.
Real Policy Interest Rates
While exchange rates may be one of the factors for consideration, it is essential to understand the role of real policy interest rates. These rates are calculated by subtracting inflation from nominal rates and matter more for monetary policy effectiveness than exchange rates.
Real policy interest rates in Canada are rising faster than in the US, and they matter more than exchange rates. The bank targets 4.5 percent, but inflation is lower in Canada and falls faster, making real rates less negative in Canada than in the US. The declining inflation rate would increase the real policy rate without a further hike.
Other Factors to Consider
While exchange and real interest rates are important factors to consider, other factors must be considered too. For example, the ongoing effects of the COVID-19 pandemic, including the possibility of new variants or other unexpected events, might impact the economy.
Furthermore, different countries have different economic environments, making it challenging to make direct comparisons. Thus, Canada’s current economic situation should be the primary factor determining monetary policy.
- The Federal Reserve has pumped trillions of dollars into the US economy since the COVID-19 pandemic began.
- The Bank of Canada is targeting a 2% inflation
Despite the expectations that Canada should follow the US Fed’s policy with interest rate hikes, the Bank of Canada’s policies is proper, considering Canada’s current economic situation. Moreover, exchange rates are not the only considerations to make since real policy interest rates matter more.
In conclusion, the arguments that the Bank of Canada should follow the US Fed with interest rate hikes are unreasonable. The exchange rate should not be the only factor that should influence a country’s monetary policy. Canada’s economy has distinctive factors to consider, and real policy interest rates matter more than exchange rates.