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Will the US Federal Reserve's rate hike impact Canadian mortgages?

The US Federal Reserve – the American central bank counterpart to the Bank of Canada – hiked their federal funds rate by 0.25% this week, bringing their benchmark cost of borrowing to a range of 4.5% - 4.75%, and signaling there will be a couple more increases to come before they can ease up on the monetary policy gas pedal.

This means variable interest rates will be rising south of the border – but could there be an impact on Canadian borrowers as well?

Given how closely intertwined the countries’ economies are, what the Fed does can often have implications for Canadian interest rates – but not always. Let’s explore the relationship between the two central banks to see what this most recent rate hike means for Canadian consumers.

Similarities between the US Federal Reserve and the Bank of Canada

Both of these central bank institutions fulfill the same purpose: they’re mandated with keeping domestic inflation close to a target of 2%, and use their benchmark interest rate (called the federal funds rate in the US and the overnight lending rate, policy rate, or key rate in Canada) to influence the overall cost of borrowing. 

When inflation is growing at its target, central banks generally keep interest rates low and stable. This allows consumers and investors to borrow cheaply, and also keeps funds liquid between financial institutions – a cornerstone of a healthy economy. Lenders also use the benchmark rate to set their own Prime rates, which in turn influence their variable borrowing products, including variable-rate mortgages, lines of credit, and auto loans.

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Speaking of inflation, it’s been a persistent thorn in the side for both the Fed and BoC over the last two years, hitting 40-year records as both economies rebounded following pandemic lockdowns; in Canada, the Consumer Price Index hit 8.1% this past June, while the US ran even hotter at 9.1%.

As a result, both central banks have been aggressively hiking their trend-setting rates since last March, bringing them from pandemic lows to 15-year highs in less than a 12-month span, the Fed by a difference of 4.5%, and the BoC by 4.25%.

Historically, the two often hike, hold, and cut rates in tandem; while there’s no hard and fast rule that the BoC must emulate the Fed, economic conditions are often similar enough in both countries to warrant the same monetary policy response. What's good for the goose is good for the gander, if you will. As well, should the BoC deviate too far below the rate set by the Fed, it risks softening the Canadian dollar, and in turn feeding inflation – the very opposite of what it’s trying to achieve.

What the Fed does can also indirectly influence the Canadian fixed cost of borrowing, as the bond market – which lenders use to set the pricing of their fixed-rate mortgage products – is highly reactive to monetary policy on both sides of the border. Canadian five-year bond yields actually dropped following the Fed’s rate announcement, leading some lenders to cut their fixed mortgage rates this week.

A diverging path

In recent months, however, it’s become clear the two central banks must take different paths. Both have been making headway with inflation, which fell to 6.5% and 6.3% in the US and Canada in December, respectively.

That’s been enough for the BoC to take a “conditional pause” on rates moving forward, and it started signaling it would “pivot” from its hiking strategy as early as last November.

In the Bank of Canada’s January 25th announcement, its Governing Council wrote that inflation has peaked and should lower further to 3% this year and back to its 2% target in 2024. As long as inflation continues to decline as expected, rate hikes are in the rear view for Canadians for the foreseeable future.

“If economic developments evolve broadly in line with the MPR outlook, Governing Council expects to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases,” the Council writes. “Governing Council is prepared to increase the policy rate further if needed to return inflation to the 2% target, and remains resolute in its commitment to restoring price stability for Canadians.” 

But the Fed wants to see inflation come down even further before it’ll consider a rate hold. In this week’s announcement, the Federal Open Market Committee stated, “The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.” 

But there is light at the end of the tunnel, as signs are emerging that the Fed could soon also wrap up its hiking cycle. This most recent hike was just 0.25%, a turnaround from a series of “jumbo” increases last year; a 0.5% hike in December and four consecutive 0.75% hikes in the preceding months.

This is cause for optimism, according to RBC Senior Economist Josh Nye. In a daily economic update he writes, “We’re on the side of the market, expecting a 25 bp hike in March will be the last of this tightening cycle, leaving terminal fed funds at 4.75-5.00%.”

The bottom line

While decisions made by the US Federal Reserve don’t directly impact Canadian borrowers, the economic reaction to their monetary policy absolutely ripples through our financial system; it’s important for those currently shopping for a mortgage rate (or are currently holding a variable mortgage term) to keep an eye on the Fed’s movement, as today’s borrowing environment can be volatile.  

Overall, though, this week’s Fed announcement shouldn't deter the Bank of Canada from its current rate hold strategy, meaning borrowers can still expect mortgage rate stability in the near future.

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