Innovation and technological change are key drivers of increases in productivity, which in turn, is the basis for higher standards of living. A study by the Fraser Institute finds that between 2014 and 2022, Canada’s ranking on the Global Innovation Index declined from 10th to 12th among the top 15 innovating OECD countries, including, among others, Britain, Germany, Australia, Korea, and the U.S. Over the same period, the U.S. increased its innovation ranking from 6th to 2nd highest. [1]

 

Slowing productivity, high household debt, and weakening housing demand are some of the reasons Canada’s economy as measured by GDP has been flat since May. This while the number of Canadians grew by 1.05 million last year, the highest annual rate on record. These new Canadians have to buy goods and services and contribute to our GDP growth, so it is logically argued that a flat GDP reading in today’s Canada means our economy is actually shrinking.

 

By comparison, U.S. GDP grew 4.9% in the 3^rd quarter of 2023. That is a big difference, and one worth thinking about.

 

Many don’t realize just how closely connected our interest rates are with the U.S. In fact, the correlation between Canadian and US government bond yields is over 88%. That is because our economies depend on one another (or at least ours does with theirs). When the American economy is doing well, the Canadian economy tends to do well, and vice versa. But this is not always the case – and right now we are seeing a divergence.

 

Here’s where things get interesting…. I have heard many comments recently that the Bank of Canada will cut rates in the Spring. The logic here is that the economy will continue weakening under the pressure of higher rates, inflation will inevitably fall to 2%, and the Bank of Canada will have the green light to lower rates.

 

But there’s problem with this that no one seems to be talking about…  what if the US economy is much stronger than ours at that point? If that were the case, and it looks like it could be, the U.S. would not have a reason to lower their interest rates, which would give the Bank of Canada much less flexibility in reducing interest rates here.

 

That is because when our rates drop too low relative to the U.S., the Canadian Dollar weakens. This means imports become more expensive (along with other currency issues). The US is our largest trading partner and provides roughly 50% of our imports. With a weaker Canadian dollar, we would effectively start importing inflation all over again. [2]

 

For better or worse, we do not make monetary policy decisions in a vacuum. The Bank of Canada knows this. In order to get meaningful rate cuts in Canada any time soon, we will need to see the U.S. economy slow down in a big way.