The Bank of Canada has cut Canadian interest rates twice over the past year and may well cut them again. In contrast, the U.S. Federal Reserve has raised rates once and odds are that they will do so again in March. How did this happen? How is it that Canadian and U.S. rates are on diverging paths, and what does it mean for our respective economies?
Here is the key difference between the U.S. and Canadian economies: they move in different directions when the price of oil declines, and that price has declined, falling by close to 70 percent since mid-2014. In the U.S., it is an unambiguous win for the economy as a whole. Although the U.S. certainly produces oil and its energy sector loses when prices fall, the oil industry does not have the same importance as it does in Canada. Meanwhile, the U.S. consumer sector is huge, and Americans typically spend savings they get at the gas pump. While they are being a little bit cautious with the spending this time around, some estimates suggest that the fall in pump prices saved Americans close to $100 million in 2015.
Lower oil prices as well as an economy that is looking better than it has in years has U.S. policymakers concerned about inflation, and has prompted one interest rate increase to date. The reality is that rates have been at extraordinarily low levels. For seven years, the benchmark interest rate in the U.S. was effectively ‘zero’, an effort by the U.S. Federal Reserve – the country’s central bank – to boost an economy and a housing market that were previously in terrible shape.
Whether it was their actions that made the difference, the U.S. economy has come back to life. From a peak of 10 percent in 2009, the unemployment rate has fallen to 4.9 percent as of December 2015. If the housing market has not made a full recovery it has at least stabilized, and in many markets has improved over the past couple of years. Accordingly, in December the Federal Reserve raised the target range for the benchmark Fed Funds rate from 0.0 – 0.25 percent to 0.25 – 0.5 percent. Although they refrained from another hike in January, it is possible that they will do so again in March.
Similar to our neighbours to the South, Canadian consumers also save money at the gas pumps when oil prices fall, but as a whole, we are far more economically dependent as a country on the energy sector.
To start there is the direct impact on job losses. In December, oil-dependent Alberta’s provincial unemployment rate rose to 7.4 per cent, above the national rate of 7.2 per cent. The first time the province has been above the national rate in twenty-seven years. Include a sharp decrease in investment spending and you have a case for lower interest rates as a way to jumpstart the economy.
As a result the Bank of Canada has done just that, and could lower them again later this year. That is not a sure thing however, given that we are waiting for the first Federal Budget from our newly-elected Liberal government, and that that budget may well include substantial government spending as a measure to boost the economy, particularly in the west. If you already have fiscal stimulus in place, you do not have the same need for monetary stimulus.
The net result of all of this is that we have a Canadian dollar that has dropped to around 72 cents U.S. in recent months and which shows few signs of recovering soon. Weak commodity prices as well as the current and growing interest rate gap between Canada and the U.S. are primarily behind the loonie’s weakness. Interestingly, the falling dollar can be thought of as helping the western provinces while spreading the pain of the oil slump to the rest of Canada. Given that oil and other commodities are priced in U.S. dollars, when the loonie falls in comparison to the U.S. dollar, the price received by Canadian producers actually rises. That is something that the Bank of Canada is certainly taking into consideration as it reviews the economic situation.
Although the low dollar is a positive to central Canada in some ways, as time goes on its effects will be increasingly negative. For now other provinces such as Ontario are increasingly seeing benefits of the better economic activity in the United States. Ontario exports rose by a brisk 10.5 per cent in 2015 and as of December the province’s unemployment rate was 6.7 percent, well under the national rate of 7.2 percent. Still, like the rest of Canada, Ontario also imports from the U.S. and those imports are getting increasingly expensive. As a result, over time the standard of living for Canadians – what they can buy with what are likely stagnant paycheques – will decline.
Putting it all together, what does it mean for the economy in 2016? The U.S. is raising rates for the ‘positive’ reason that their economy is doing well. As they continue to grow, Canada is likely to be a beneficiary. Low Canadian interest rates can only be positive for the housing market, and for the management of Canadians’ debt burdens, a substantial bright spot in what may be an uneven economic outlook.