The Canadian and American economies are deeply intertwined. With the US Federal Reserve cautious amid mixed labor market signals and rising inflation concerns, the Bank of Canada it just cut its key interest rate to 3.75%. — reducing it by half a percentage point.

Strong US job growth and cooling inflation could lead to a smaller Fed rate cut compared to its previous cut and Canada’s recent cut. I might pause the rate as well entirely, which could change economic conditions in the US and Canada in the coming months. In the future The US election complicates the matter further.

In Canada, cooling inflation, manufacturing sales slowdown and more prudent consumer spending opens the door to another rate cut of half a percentage point by the end of the year.

But does the Bank of Canada have the ability to offset changes in US monetary policies through its own monetary instruments? In fact, how much room does he have to deviate from US policy?

The monetary conditions are transmitted from the world’s largest financial centers to the rest of the world through gross credit flows and leverage. Any policy differences between Canada and the US have an immediate impact on Canada, including spillover effects on loonie exchange rates and other large-scale economic and social effects.

Canada’s double trilemmas

Canada’s main challenges include economic growth as potential recession wars, taming inflation, housing, managing interest rates while private and public debt is skyrocketing and stabilizing Canada’s commodity-linked currency in an increasingly volatile geopolitical environment. Failure to meet these challenges could lead to severe systemic imbalances.

The Bank of Canada has good reasons to cut interest rates to 2.5 to 3.5%, but this could have a significant impact on the loonie.

Canada faces two sets of trilemmas: a monetary one for the central bank and a fiscal one for the government. On the monetary side, stable exchange rates, independent monetary policy and financial market openness are three objectives that cannot be achieved all at once. European countries have sacrificed monetary independence in exchange for a strong euro and financial openness.

Canada, on the other hand, opted for free capital mobility and an independent monetary policy at the expense of exchange rate stability. This allows the loonie to be determined by market forces, giving the central bank the ability to adjust interest rates while capital moves freely across the border.

On the fiscal side, the government is struggling climate change, immigration and wealth inequality. However, there is also strong public resistance to higher taxesand public debt and deficits are currently at alarming levels.

If central banks are at odds

If the Bank of Canada were to cut interest rates while the Fed does not, it would likely depreciate sharply, forcing a response. Such a divergence it happened in june 2024with Fed following a 0.5 percent reduction only in September.

On such short-term deviations, sterilization is usually implemented to mitigate the depreciation of the loonie by purchasing Canadian dollars and sale of reserves.

If central banks were to remain at odds over the long term, a decrease in money supply as investors flee would likely cause a decline in domestic bank lending, which is already under pressure from public and private debt and increased default rates.

This could lower interest rates over the longer term and put additional pressure on the economy through capital account. If investors believe the central bank is merely delaying the inevitable depreciation of its currency, it could also strengthen it carries the dynamics of commerce — an investment strategy in which money is borrowed at a low cost in one currency to obtain higher returns from investments in another currency.

The bond market would also react with notable effects in key economic sectors and asset valuations. Long-term interest rates tend to align more across countries than short-term rates, especially if global factors influence real rates or if investors seek safer assets.

While the Bank of Canada can set its policy rate independent of the Fed rate, it has less control over the long term. Long-term rates are linked to exchange rates and reflect expectations for future short-term rates and risk factors. Mortgage rates and corporate loan rates would also be affected.

Monetary policy cannot be the only answer

Mandate of the Bank of Canada is “to keep inflation low, stable and predictable”. While this can be accomplished through rate cuts, the departure from US policy will have far-reaching effects on the Canadian economy. These impacts will be uneven, with investors and indebted banks likely to benefit, while the working class may bear the brunt.

The Bank of Canada focuses on providing liquidity to the financial sector, often with little regulation or oversight. However, this approach tends to overlook the challenges facing the working class. In 2022, for example, Bank of Canada Governor Tiff Macklem advised employers not to raise wages to match inflation over the concern that a wage-price spiral would take place.

Even if the central bank wanted to address these issues, it is limited by the ability to manage multiple outcomes with a single instrument. Accordingly, the central bank should report not only on inflation, but also on the overall trade-offs of rate cuts.

The Bank of Canada has a vested interest in reversing the effects of another rate cut, especially as it could trigger a long-term “capital famine” and weaken the Canadian dollar. In the short term, divergences with the US will likely be manageable, but in the long term, currency depreciation may be inevitable to keep the economy afloat.

Monetary policy is vital, but it is only the first line of defense against inflation. To truly address Canada’s economic problems, both monetary and fiscal policies must work in harmony with a broader public discussion that goes beyond inflation.

Sorin Rizeanu is a university assistant at the Gustavson School of Business at Victoria University

He does not work for, consult with, own stock in, or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations outside of their academic appointment.