Canada holds Rates Steady while the US still needs to Reign in Inflation

  • David Campbell

Blog by Insight Capital Partners

Who pays part of the bill? The trusty Ole Loonie!

The US Federal Reserve funds rate and the Canadian Bank of Canada rate are two key benchmark interest rates that have a significant impact on the global economy. The historical maximum difference between these rates has varied over time, reflecting changes in the economic conditions of both countries.

In the early 1980s, the US and Canadian economies were experiencing high levels of inflation, and interest rates were correspondingly high. At this time, the difference between the Federal Reserve funds rate and the Bank of Canada rate reached a maximum of around 7%, reflecting the severity of inflationary pressures in both countries.

During the 1990s and 2000s, the difference between the two rates began to narrow, as both countries implemented policies to reduce inflation and promote economic growth. The spread reached a minimum of around 0.5% in the mid-2000s, reflecting the relatively stable economic conditions in both countries at that time.

In the aftermath of the 2008 financial crisis, both the US and Canada implemented aggressive monetary policies to stimulate their economies, leading to a widening of the spread between the two rates. The maximum difference between the two rates reached around 4% in the years following the crisis, reflecting the different economic conditions and policy priorities of the two countries. The impact was to drive the Canadian dollar towards parity with the US for the ensuing four to five years.

Today, the difference between the Federal Reserve funds rate and the Bank of Canada rate remains relatively narrow, reflecting the fact that both countries have recently experienced low inflation and stable economic growth over the past 10 years. However, as economic conditions change, the spread between the two rates is likely to expand with US rates moving higher than Canadian rates in order to tame stubborn inflation in the US. Thus, reflecting the ongoing complexity and interdependence of the global economy, the Bank of Canada will have a difficult decision to make with respect to its monetary policy vis a vis the dollar.

From an expectation point of view, the Loonie has weakened through 1.40 both in early 2016 and again during the COVID crisis in early 2020. Prior to that, the painful 10-year period of the 1990’s where Canada was mired in several separation votes (which fortunately did not come to pass) in Quebec caused the Loonie to weaken out ultimately to 1.60 CAD/USD post the dot com bust in 2002. Bottom line, history has shown the CAD can weaken off to a greater extent from current levels and we expect will test the 1.45-1.50 range before the inflation bogey is tamed in the US. The result is the old story of the US sneezes and Canada catches the cold…the Loonie will again be the flag on the rope in a tug of war game between national and global politics (where the global side has the current momentum!).

Some Canadian Dollar History for Context (and Bedtime Reading)

The Canadian and US dollar have a long and intertwined history that dates back to the 19th century. In the early days of Canada, before Confederation, a wide range of currencies were in circulation, including British pounds, Spanish dollars, and various colonial currencies. However, after Confederation in 1867, the new Canadian government sought to establish a national currency that would help promote economic growth and stability.

In 1871, the Canadian government introduced the first Canadian dollar, which was pegged to the US dollar at a rate of $1 CAD to $0.92 USD. This peg remained in place until 1914, when the outbreak of World War I caused both currencies to fluctuate wildly due to the economic turmoil of the time.

After the war, the Canadian government sought to stabilize its currency by pegging it to the British pound, which was then the world's dominant currency. This peg remained in place until 1931, when the Great Depression led to the abandonment of the gold standard and a period of floating exchange rates.

During World War II, the Canadian and US dollars became closely linked as both countries worked together to finance the war effort. In 1949, the two countries signed the Canada-US Currency Agreement, which established a fixed exchange rate of $1 CAD to $0.91 USD. This rate remained in place until the 1960s, when inflation and other economic factors led to a series of devaluations and fluctuations.

Today, the Canadian and US dollars continue to be closely linked, with the two currencies often trading at near-parity (from a global currency perspective). However, fluctuations in the global economy, changes in trade policies, and other factors can cause significant shifts in the relative values of the two currencies.

In the early days of the Canadian dollar, the spread between it and the US dollar was relatively small, reflecting the fact that both countries were still developing and had similar economic profiles. However, as the Canadian economy grew and diversified, the spread began to widen, reflecting differences in the countries' resources, industries, and trade patterns.

During the 1970s and 1980s, the spread between the Canadian and US dollar was particularly wide, as Canada struggled with high inflation and a large national debt. At the same time, the US economy was growing rapidly, and the US dollar was becoming the world's dominant currency.

In the 1990s, the spread between the two currencies began to narrow, as Canada implemented a series of economic reforms and the US economy faced a number of challenges, including a recession and financial crisis. The two currencies traded at near-parity for much of the 2000s, reflecting the increasing integration of the North American economy and the growing importance of trade between the two countries.

In a larger context, the historical relationship between the Canadian and US dollar has been marked by a series of pegs, devaluations, and fluctuations, reflecting the complex economic and political forces that have shaped North America over the past century and a half. Despite these changes, the two currencies remain closely linked and continue to play a vital role in the region's economy and international trade.