Feature Article
Bank of Canada holds firm:
What's next for interest rates?
In early December, the Bank of Canada announced that it was keeping its overnight rate stable at 1% for the second consecutive month, this following three straight hikes of 25 basis points each. The bank cited threats to the economy caused by falling exports and the European debt crisis as reasons for caution1.
However, as the Bank's Governor Mark Carney recently noted, the U.S. Federal Reserve's Quantitative Easing II policy also played a key role. "Given the weakness in the U.S. economy [a reason for QE] and tensions on the foreign exchange markets [a consequence of QE] there's a limit to withdrawing very accommodative monetary policy…that's why we took a pause at our last meeting," stated Carney.
Canada on pause
In a nutshell, the Bank of Canada is finding it hard to raise rates at a time when our largest trading partner is opting for a looser monetary policy. That said, once QE II ends, Canada's central bank is likely to resume tightening its fiscal policies. BMO Capital Markets Economics believes that the first rate hike will come in May, with three more increases to follow through the course of 2011.
Higher interest rates would likely lift the Canadian dollar against the greenback, possibly boosting it above parity. A stronger Loonie would make it more difficult for Canadian exporters to attract U.S. clients. On the other hand, Canadian companies seeking to retool or to reinvest in new technology would get a break, as most computer equipment, software and machinery is priced in U.S. dollars.
Interest rates in the U.S.
The Fed's policy interest rate, which is currently at zero, is likely to remain there throughout 2011, marking the third straight year of no changes. At its current pace, the U.S. recovery will not create nearly enough jobs anytime soon to make up for the eight million lost during the recession. U.S. economic growth is currently forecast to accelerate in 2011 to 3%, boosted by another round of fiscal stimulus, but still below typical post-recession recovery rates. As a result, the Federal Reserve will remain under enormous pressure to keep short-term interest rates low.
In fact, in early November the Fed went one step beyond its traditional operating procedures by announcing that it would buy US$600 billion of longer-term Treasuries in an attempt to bring down medium-term interest rates as well.
As a result, by next spring, bond yields are likely to be noticeably lower, with 10-year yields averaging 3.0%. The Fed has also said that it will regularly review its QE II purchases and adjust them as needed to foster maximum employment and price stability.
Over the short term, the U.S. dollar has weathered the quantitative easing process quite well, thanks in part to a "flight to safety" caused by European sovereign credit concerns. However, towards the second half of next year, as quantitative easing ends, the greenback will likely resume its downward slide against the Euro and the so-called commodity currencies (including the Canadian dollar).
For more in-depth information on Canadian and U.S. interest rates, visit us online at BMO Capital Markets Economics.