As Canada tries to diversify away from the United States, it will be hard-pressed to decouple from one institution: the U.S. Federal Reserve.
The Fed, America’s central bank, is one of the most influential institutions in the world. By setting interest rates for the world’s largest economy, it significantly impacts countries all over the globe.
For Canada, with an open capital market and heavy trade exposure to the U.S., this is acutely the case.
Now, changes at the Fed are likely to cause Canadian interest rates to rise.
In May, the Federal Reserve got a new chair, Kevin Warsh. Last week, Warsh unveiled the rosters for five task forces that will comprehensively review the bank’s approach to monetary policy. Many of the 15 experts on these task forces can be considered the who’s who of international finance.
They include the former heads of England, India and Brazil’s central banks, a Nobel laureate, academics from leading universities, and tech and corporate executives. It also includes Canada’s own William White, an economist who has held top positions at the Bank of Canada, OECD and Bank for International Settlements.
In prior statements, Warsh has made clear that two prominent monetary policies are in the Fed’s crosshairs: forward guidance and quantitative easing.
Forward guidance is the practice of signalling the future direction of interest rates. Forward guidance can help stimulate the economy when interest rates are at or near zero. However, it can also tie the hands of the central bank if inflation does appear quickly.
Quantitative easing, we wrote recently, is where central banks print new money to purchase government bonds. QE can stabilize financial markets and push interest rates down. But it can also fuel inflation by flooding the economy with money that chases a fixed supply of goods.
Both practices have also been used by Canada’s central bank in recent years.
These possible policy changes might seem wonkish, but they have the potential to have a significant impact on the Canadian economy through higher interest rates.
Suspending forward guidance could do this by giving the Fed more flexibility to raise interest rates in response to changing market conditions.
Reversing quantitative easing would mean selling the Fed’s multi-trillion dollar portfolio of U.S. government bonds. That selloff would likely drive bond prices down, leading to higher interest rates. (Bond prices and interest rates move in opposite directions, so when bond prices fall, interest rates rise.)
Higher U.S. interest rates would in turn likely lead to higher interest rates in Canada, as Canada’s own bond market competes globally. As U.S. bonds become more attractive to international investors, some would dump Canadian bonds, driving Canadian interest rates up.
Neither of these changes is certain to happen. However, if they go through, Canada is in an especially vulnerable position, as both its consumers and governments are heavily indebted.
Canadian households have among the highest debt loads in the developed world. Collectively, our households owe 180 per cent of disposable annual income — a level higher than what U.S. consumers carried during the financial crisis.
Likewise, federal and provincial governments collectively carry significant debt — and are spending more and more on interest charges.
Ottawa alone is estimated to have spent nearly $59 billion on debt charges last fiscal year. This is equivalent to roughly 10.6 per cent of all federal revenues — a number that has nearly doubled from five years ago.
Those numbers look heavy now. But with Warsh at the helm of the Fed, they may only get worse.
To avoid throwing more money at debt payments, our governments will need to address the variables that are within their control. This includes bringing down government spending and/or boosting tax revenues to pay for its programs.
To date, the federal government has moved in the opposite direction on both fronts. It has increased spending and cut income taxes.
While markets have remained sanguine so far, we may be entering a new era.
The Fed has given its task forces a mere six months to complete their reviews. Clearly, it is keen to move quickly. Canada may need to act quickly and decisively too.
