The Bank of Canada and the U.S. Federal Reserve both began raising interest rates in March, 2022. In Canada, that’s pushed the economy to the edge of a recession. South of the border, the U.S. economy is defying gravity.

The differences in economic performance have become increasingly stark in recent months. Canadian consumers are cutting back while Americans continue to splurge. U.S. businesses are investing in buildings and equipment, building up inventories and bringing on new workers, while Canadian companies are pulling back and bracing for a period of slow growth.

The picture is clearest when you look at gross domestic product. Canadian GDP contracted between April and June then stalled through the summer and early fall. In the United States, GDP grew at an annualized rate of 2.1%in the second quarter and accelerated to a whopping 4.9% in the third quarter.

What explains these divergent paths when inflation has followed a similar trajectory in both countries? Here are the key reasons why Canada and the U.S. are trending in different directions, and what that means for interest rates.

Canadian households hit harder by interest rates 

When interest rates rise, debt levels matter a lot. More money going to interest payments means less to spend on other goods and services. Canadian household debt was 102% of GDP in the first quarter of 2023, according to the Bank for International Settlements. In the United States, it was 74%.

“Even before the pandemic, even before this run up in rates, Canadians were spending about 15 cents of every after tax dollar [servicing debt], and Americans were spending about 10 cents on every dollar,” said Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce. “So the starting point was a higher interest burden, and it’s one that’s rising more sharply in Canada than it is in the U.S.”

The reason interest payments are rising more quickly in Canada has to do with how mortgages are structured. American homebuyers typically take out 30-year mortgages, allowing them to lock in interest rates for an extended period of time. In Canada, most mortgages reset every five years. That means rising interest rates are felt relatively quickly.

Since the Bank of Canada began increasing interest rates in the spring of 2022, around 40% of Canadians with mortgages have seen their monthly payments increase. That proportion will rise considerably over the next few years.

“It’s not just that Canadians are spending more on interest payments. They’re also choosing to save more of their after-tax income to brace themselves for those higher payments to come,” Mr. Shenfeld said.

Washington’s more aggressive fiscal policy

Both Canada and the U.S. have stimulative fiscal policies in place, but on vastly different scales. Ottawa is expected to post a deficit of more than 1% of GDP this year, but Washington’s deficit is closer to 6%. In the third quarter, U.S. federal spending rose 5.5% annually, making it one of the fastest growing sectors of the economy.

“Whether you look at just straight government spending or industrial policy incentives, the U.S. is running a much-more stimulative fiscal policy than Canada,” says Sal Guatieri, senior economist at Bank of Montreal.

Canada is pursuing its own industrial policy, but the pace of rollout has been slower. “A lot of the tax measures for businesses that Canada has announced haven’t even been defined yet,” said Scotiabank economist Rebekah Young.

However, while U.S. fiscal policy is helping to boost growth south of the border, it’s also creating headaches for the Federal Reserve by fanning inflation in that country. “It’s producing stellar economic growth but at the peak of an economic cycle when the U.S. doesn’t really need it and monetary policy doesn’t welcome it,” said Mr. Guatieri.

Low productivity a drag on Canada’s economy

Productivity measures economic output per hour worked. If productivity was even holding steady, the surge in Canada’s population – and the increased supply of workers and demand for goods and services that comes with that – would be expected to power growth. But productivity has declined in 11 of the past 12 quarters. In the U.S., on the other hand, productivity climbed in the third quarter by 4.7%, the fastest pace in three years.

The drop in Canadian productivity reflects weak business investment in machinery and technology that would help workers do their jobs more efficiently.

What does this mean for interest rates?

Many economists believe the Bank of Canada and the Federal Reserve are done raising interest rates. Speculation on Bay Street and Wall Street is shifting to when the central banks might begin cutting rates.

The relative weakness of the Canadian economy suggests that the Bank of Canada will move first, said Mr. Shenfeld. His team at CIBC is projecting the first rate cut from the Bank of Canada around the middle of 2024, followed a few months later by the Fed. Interest-rate swap markets, which capture market expectations about monetary policy, are pricing in cuts by both central banks starting in summer 2024.


Source: Globe and Mail
Source: Financial Post