Monetary policy, interest rates and the Canadian dollar

Like a canoe navigating the shifting currents of Canada’s rivers, the Canadian dollar flows with the rhythms of global markets, risk appetites and economic growth. This floating exchange rate allows for independent monetary policy that can be adapted to the needs of the Canadian economy. By summer 2024, inflation in Canada returned near the Bank of Canada’s 2% target from a peak of just over 8% in 2022. But in the United States, high inflation was more persistent and hovered above its target for most of the year. Because the economies started to follow distinct paths in Canada and the United States, investors and economists anticipated that a wedge would develop between the interest rates set by the Bank and those set by the Federal Reserve Board. Unsurprisingly, this wedge weighs on the value of the Canadian dollar against the US dollar. When interest rates in Canada decline more quickly than they do in the United States, the value of the Canadian dollar also declines to equalize the returns from investing in one country or the other. As a rule of thumb, when the 1-year interest rate in Canada drops by 1% below that of the 1-year interest rate in the United States, the exchange rate should drop by 1%. Without that price adjustment, investors would move their investments across the border to earn a higher return. But the decrease in the value of the Canadian dollar in 2024 was greater than the wedge that had grown between the paths of the interest rates for the two countries. That’s because investors also consider the risks of investing in one currency versus the other—not just the difference between interest rates. In 2024, uncertainty clouded international trades and financial markets, and market participants embedded a large risk premium across the exchange rates of most currencies against the US dollar. This broad exchange rate risk premium explains roughly two-thirds of the drop in the value of the Canadian dollar in 2024. Historically, deviations between the path of interest rates in the United States and Canada have tended to dissipate with time, and the major sources of risks and uncertainties have eventually been resolved. Ultimately, other long-term factors play a greater role in determining the value of the currency. They include the following factors, which usually move slowly and are hard to detect: • productivity and the composition of real activity • fiscal and trade policies • long-run inflation rates