Q2 2024 Macroeconomic snapshot: Interest rate cuts are not necessarily a death sentence for the loonie

The Bank of Canada (BoC) lowered its overnight interest rate in June to 4.75%, the first of several cuts expected to be delivered over the next twelve months. While lower rates do not bode well for the Canadian dollar, that’s not to say the loonie is doomed. The U.S. Federal Reserve (Fed) is also poised to cut rates later this year, bringing an extended period of US dollar strength to an end.

Why is now the time for cuts to begin?

While the BoC analyzes many data points when setting the course for monetary policy, one of the more important pieces of data is core inflation. Core inflation strips out the more volatile components of the consumer price index to give a broader sense of underlying price pressures in the economy. There are a multitude of ways to calculate core inflation, but today we look at the all-items excluding food and energy from the last three months (calculated at an annualized rate). Looking at the last three months’ data gives us a better understanding of recent trends compared to a year-over-year calculation of inflation.

There was concern in the latter half of 2023 that inflation was ‘sticky’ (Figure 1). From August to December 2023, this measure of core inflation hovered above 3.0%. While this was down from the peak in 2022, it was still too high for the BoC and, more importantly, stopped trending downward and instead trended sideways. However, in the last three months, this rate has been below 2.0%. In fact, it’s at the lowest level since the spring of 2021. As well, other measures of core inflation are showing similar improvement.

Figure 1: Recent data showing core inflation moving into sustainable territory

All-items excluding food and energy

Source: Statistics Canada

Given this improvement in core inflation, slowly but surely moderating wage growth, and general economic weakness, the path is clear for the BoC to start cutting the overnight rate. FCC Economics expects June’s rate cut to be followed by two additional 25 basis point cuts in the second half of this year, putting the overnight rate at 4.25% by year-end. In other words, rates will be coming down, but only gradually.

To be sure, the BoC will have to keep an eye on what’s happening south of the border as it adjusts its monetary policy. Expectations of what the Fed will do have shifted rapidly in 2024. At the onset of the year markets were betting on upwards of six rate cuts; as of today, expectations are for only one rate cut (Figure 2). A lot of this change in expectations is due to recent inflation data in the US. The Fed’s preferred measure of core inflation has been sticky in the last three months, much like how the BoC’s preferred measures of core inflation were in the latter half of 2023.

Figure 2: Policy rate projections for the rest of 2024

Sources: FCC Economics, CME

Will the Canadian dollar crash?

The BoC cutting sooner than the Fed will temporarily widen the gap between the two countries’ key policy rates. On paper, this should be negative for the Canadian dollar, which is why some analysts have come out and announced impending doom for the loonie. Amid the bleak outlook, however, there are some factors that could help the loonie find some support later this year.

The most important factor in determining the path of the Canadian dollar over the next year is the US dollar (USD). Note that the USD, relative to all other currencies – not just the loonie – is the strongest it has been in over 20 years. The path towards this high level began in March 2022 when the Fed began increasing its federal funds rate (Figure 3).

Figure 3: The US dollar is the strongest it’s been in over 20 years

Sources: Barchart, FCC Economics

Whatever the timing and pace, once the Fed starts to cut its rate, this is likely to put downward pressure on the US dollar, all else being equal. So, while the Canadian dollar could be under pressure over the near term, don’t rule out a comeback towards year-end as the US yield advantage diminishes.

Another factor to consider is Canada’s improving current account balance (Figure 4). The current account balance is, in essence, a measure of a country’s net trade: a negative number (deficit) means it’s a net importer of goods and services, while a positive number (surplus) means it’s a net exporter. An exchange rate is essentially a price that is determined like the price of any other good: when demand increases, the price (value) of the Canadian dollar will go up, all else being equal. And, when the value and/or quantity of Canadian exports increases, so too will the Canadian dollar.

With the completion of the Trans Mountain Expansion project, which effectively raises Canada’s oil shipping capacity by nearly 600,000 barrels per day, and assuming nothing else changes, look for the trend improvement in the current account to continue. That should provide some support to the Canadian currency amid ongoing headwinds.

Figure 4: The Canadian current account deficit has narrowed since 2013

Source: Statistics Canada

Bottom line

There are many other economic drivers of exchange rates than the difference between central bank key policy rates. With the BoC having begun its rate-cutting exercise in advance of the Fed, there is likely to be some downward pressure on the Canadian dollar in the near-term. However, there are arguments to be made that the loonie will regain some strength towards the end of the year, particularly as the Fed begins its own rate-cutting exercise and the US dollar’s recent sustained period of strength begins to fade.

The table below summarizes FCC Economics’ outlook of select economic variables.

Summary of forecasts of key economic variables

Sources: FCC Economics, Bloomberg

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Graeme Crosbie

Senior Economist

Graeme Crosbie is a senior economist at FCC. His focus areas include macroeconomic analysis and insights and monitoring and analyzing Canada’s food and beverage industries. Having grown up on a dairy farm in southern Saskatchewan, he occasionally comments on the health of the dairy industry in Canada.

Graeme has been at FCC since 2013, spending most of that time in risk management. Graeme holds a master of science in financial economics from Cardiff University and is a CFA charter holder.