How far can the BoC diverge from the Fed?

Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets. A podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Katherine Judge: Welcome to Eyes on the Economy. I’m Katherine Judge, a Senior Economist at CIBC. I’ll be your host for today. Today is June 3rd and I’m joined by my colleague Ali Jaffery, who recently released a paper with Andrew Grantham titled, Finding the Limit: How far can the Bank of Canada diverge from the Fed? Ali joins me to discuss their findings.

Ali Jaffery: Thanks for having me, Katherine.

Katherine Judge: My pleasure. So what is this piece about?

Ali Jaffery: So as it’s become apparent that the Bank of Canada is going to ease policy before the Fed and we think that it’s very likely start this week, one of the most common questions we’ve been getting from our clients is how far the BoC and the Fed can diverge. And so in these discussions, the main takeaway I gather is investors and market pricing really embeds a fairly material role of the Canadian dollar and monetary policy still. And largely because they expect inflation and inflation expectations to adjust pretty quickly the shifts in our dollar. And that’s a view that seems out of step with how the broader macro community and that most importantly includes central banks have thought about this issue for a little while. So what we do in this piece is to try to bring everyone up to speed on the latest thinking on how exchange rate movements and monetary policy divergence impact inflation. And we do that using a mix of external estimates from recent academic work, analysis from staff at the Bank of Canada, and our own empirical work. And we identify the channels through which monetary policy divergence impacts Canadian inflation and by how much.

Katherine Judge: So unpack that last part. Tell us about the inflationary impacts that you do find.

Ali Jaffery: So our bottom line is that the Bank of Canada has scope to diverge from the Fed and that’s not uncommon in history actually. And a rough ballpark estimate is that 100 basis points of divergence would boost total inflation by 0.1 to 0.4 percentage points in the long run, with the middle of that being our base case view. Now, however, that estimate reflects several things and let me try to unpack those important forces. So first is we’re measuring a particular scenario against a case of no divergence. What we have in mind in this situation is a situation which the Fed holds rates higher for longer as insurance against bumpy inflation, as opposed to a belief of persistently stronger demand in the US economy. So on economist speak, that’s a foreign monetary policy shock and not a foreign demand shock for Canada. And also this is happening at a time where the BoC is cutting rates because of weakness in the Canadian economy. So this is important because the impact of divergence depends on why you have the divergence. Because that will impact how the exchange rate moves and how firms ultimately choose to pass on or absorb the costs of a higher exchange rate. So in other words, the shocks to the economy and the state of the economy matter a lot in determining these impacts. And in this environment that we’re in currently, where we see slack opening up in Canada, and US demand not rapidly accelerating, and I know that’s something we can talk about in detail later time, Canadian firms don’t have a lot of scope to pass on higher costs from a weaker dollar, which would suggest more modest pass-through in inflation to this case. Now, the second point here is a broad range of literature suggests that movements in the dollar have modest to small impacts on inflation. The average impact of a 10% depreciation of the Canadian dollar raises total inflation in Canada by 0.9 percentage points in the long run and core inflation by just 0.3. And here we’re trying mainly to use estimates that take into account the scenario that I’m talking about. In general, they’re not too different compared to other scenarios or other types of shocks. This long run impact would take a year or more to build and then would unwind. Central bankers only really worry about sustained movements in the exchange rate, as compared to one time or short time, FX fluctuations that can cause a price level to shift, but won’t really generate continued price growth. Now, the last point about this analysis is that we also take into account the other impacts of monetary policy divergence, because monetary policy divergence doesn’t only impact inflation through the exchange rate. So there are two offsetting forces that dampen these impacts that I just mentioned. Higher rates in the US will weaken demand for Canadian exports, slowing the Canadian economy a bit and thereby putting downward price pressure in Canada. And also higher rates in the US will spill over into our rates, tightening financial conditions, including mortgage rates to some extent. And the Bank of Canada has to balance against that. So these channels offset about half of the inflationary impact that I mentioned. So overall, thinking through these and some other factors, we came to the conclusion that the bank could sustain monetary policy divergence of 100 basis points for some time, perhaps even a bit higher than that, with overall modest inflationary consequences.

Katherine Judge: So it sounds like a lot of this also depends on the exchange rate and how that responds to the level of divergence between the central banks.

Ali Jaffery: That’s right. It’s difficult to know that. And we’ve partly anchored our view on some recent literature and our estimates that a US monetary policy shock or surprise of 100 basis points would affect the Canadian dollar by 6% to 8%. And of course, the other part is looking at what the exchange rate has done so far. Since the end of 2022, we’ve seen about 5% to 6% depreciation in the CAD. And that at least partly lines up with when the market started price and divergence. Currently, the market is thinking about 50 basis points so far. So that means some of the pass-through and exchange at weaker end has already started. We think the CAD has a bit more to fall as the market view evolves. But of course, there’s uncertainty around how CAD will move and the various factors that will affect it as well. Commodity prices, of course, matter very importantly for Canadian dollar, as do other global factors, which will affect the FX risk premium. But even if our central scenario is wrong and we see the CAD fall a bit more than we expect to 1.4 or even weaker, we still expect fairly modest inflationary implications.

Katherine Judge: So how do you think the Bank of Canada is approaching this issue?

Ali Jaffery: Based on what the governor has said at his April press conference, what the Bank of Canada’s main projection models say, my hunch is that they would have a broadly similar view that monetary policy divergence is not going to be that costly from an inflationary perspective. The bank cares a lot about core inflation, of course, as the operational guide to monetary policy. Most of the estimates point to a very negligible impact on core, you know, as a lot of the pass-through reflects commodity-related items, like gasoline and fresh fruit that are priced in US dollars. So that gives them some license to look through orderly downward shifts in the dollar. And also the main drivers of inflation from the Bank of Canada perspective are inflation expectations, slack, and the range of global forces. We find that core inflation is at least three times more sensitive to shocks and labor market slack and supply chain disruptions than it is to changes in the dollar. So their attention is going to be on those forces in dialing in the level of monetary policy restrictiveness for that broader supply demand balance. And we take them at their word when they say they view the exchange rate as a shock absorber and don’t worry about any particular level of the Canadian dollar. But let me kind of turn the tables here and ask you as a resident Edmontonian, who’s going to win the Stanley Cup this year, Katherine?

Katherine Judge: (laughs) I’m obviously going to say the Oilers and this is an economics podcast. You have to look at the hard data. So the Oilers have the two best players in the series, including the best player on the planet and the best playoff performer over the past half decade. So sounds pretty good. Sounds like they’re headed towards winning the Stanley Cup to me.

Ali Jaffery: Respect. I’m with you on that

Katherine Judge: Thanks for coming on, Ali. That was a great summary ahead of what the Bank of Canada will be looking at over the next couple of months.

Ali Jaffery: My pleasure, thanks for having me, Katherine.

Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.

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