Despite US Big Step Forecast... Canada Faces Monetary Policy Test with Interest Rate Hold

G7 Halts First Interest Rate Hike
Impact of Reduced Household Consumption and Corporate Investment
Canadian Dollar Hits 5-Month Low

As the Bank of Canada had forecasted, it kept the benchmark interest rate unchanged. This contrasts with the monetary policy stance of the U.S. Federal Reserve (Fed), which has left open the possibility of a big rate hike (a 0.5 percentage point increase) this month. The background for halting rate hikes is the decline in inflation and slowing economic growth, raising attention on whether Canada can maintain an independent monetary policy.

The Bank of Canada (BoC), Canada's central bank, held the benchmark interest rate steady at 4.5% on the 8th (local time), becoming the first among the Group of Seven (G7) countries to pause rate hikes. Earlier, the BoC hinted at ending tightening by raising rates by 0.25 percentage points in January, and by holding rates steady this time, it concluded eight consecutive rate hikes that began in March last year.

The BoC explained that the economy is slowing faster than expected, with household consumption and business investment contracting, as the reason for stopping rate hikes. Canada's inflation rate slowed from 8.1% in June last year to 5.9% in January this year. Exposure to interest rate-sensitive sectors such as housing and durable goods meant the effects of rate hikes were quickly reflected. The BoC forecasted that the growth rate would be close to 0% through the third quarter of this year.

The BoC stated, "Recent data align with our expectation that inflation will fall to the 3% range by mid-year," adding, "Over the next few quarters, economic growth slowdown will ease pressures on goods and labor markets." It also noted, "If economic activity exceeds expectations, we are prepared to raise rates again."

Some market participants also predict that the BoC could lower the benchmark interest rate from the current 4.5% to 4% within this year.

This monetary policy stance is the exact opposite of the Fed's recent hawkish remarks that have sparked fears of tightening. Fed Chair Jerome Powell indicated during two days of congressional hearings on the 7th and 8th that "the terminal rate could be higher," suggesting the possibility of increasing the rate hike size again this month. If the Fed strengthens tightening and revises its path, there are expectations that Canada's monetary policy could face a test.

Immediately after the BoC's rate hold, the exchange rate surged. The Canadian dollar traded at around 1.38 against the U.S. dollar, marking its lowest level since October last year. Concerns have emerged that capital outflows from Canada and rising prices of imported goods priced in U.S. dollars could again increase inflationary pressures. The fact that the labor market remains robust is also a burden.

Andrew Kelvin, TD Securities' Chief Canadian Strategist, said, "The big picture remains that for inflation to return to 2%, the Canadian economy must effectively slow down over the coming months," adding, "Each month that resilient economic data emerges will increase pressure on the BoC to raise rates."