From the Fraser Institute

By Steven Globerman and Lawrence Schembri

The Bank of Canada’s decision last week to lower its policy rate by 50 basis points increases the gap between the U.S. Federal Reserve’s policy rate and the Bank of Canada’s rate to approximately 130 basis points. While this gap might close somewhat if the Federal Reserve lowers its rate at its meeting this week, a substantial U.S. premium will still exist.

Since borrowing rates are tied to policy rates, interest rates in Canada will remain well below those in the U.S. for the foreseeable future. This gap will continue to put downward pressure on the value of the Canadian dollar against the U.S. greenback, as investors favour higher-earning U.S. dollar-denominated assets over Canadian dollar assets. President-elect Trump’s threatened trade actions against Canada could also exert further downward pressure on the loonie, especially if the Bank of Canada responds to Trump’s actions by making additional rate cuts. For context, it took $1.33 Canadian dollars to purchase one U.S. dollar on January 1, 2024, compared to $1.43 Canadian dollars on December 13, 2024. This represents a substantial depreciation in the Canadian dollar’s value of approximately 7.6 per cent over the period.

What effects will a declining Canadian dollar have on the Canadian economy?

In short, it will increase demand for domestic output and labour and put upward pressure on inflation via higher import prices, and it could also lower productivity growth and further hurt living standards.

Why the impact on productivity?

Because Canada imports most of its machinery and equipment (including information and communications technology) from the U.S. and other countries, and investment in this type of physical capital helps drive productivity growth. A declining Canadian dollar makes capital equipment imports more expensive, thereby discouraging investment and slowing productivity growth. A declining Canadian dollar may also shelter domestic firms from foreign competition, which could dampen their incentive to invest in productivity-enhancing assets, even if they price their output in U.S. dollars.

Hence, if the Canadian dollar remains weak against the U.S. dollar and other currencies, it may be more difficult to reverse Canada’s productivity woes. Again, productivity—the amount of GDP per hour of labour the economy produces—is key to improving living standards, which have been on the decline in Canada. From July to September of 2024, the economy grew by 0.3 per cent yet per-person GDP (an indicator of living standards) fell by 0.4 per cent (after adjusting for inflation).

Canada also indirectly imports technology via direct investments made by U.S.-based companies in their Canadian subsidiaries. While a declining Canadian dollar makes it cheaper for U.S. companies to buy assets in Canada, it also reduces the U.S. dollar value of profits earned over time in Canada by American-owned companies. This phenomenon, combined with an unstable Canadian dollar, might discourage inward foreign direct investment and associated technology transfers by increasing the financial uncertainty of such investment.

To be clear, this is not a criticism of the Bank of Canada’s move last week to help lower domestic interest rates given the Bank’s primary mandate to meet its inflation rate target of 2 per cent. Rather, governments—including the Trudeau government—must enact policies to encourage business investment in productivity-enhancing assets.

For starters, policymakers should reduce business tax rates and the tax rate on capital gains, to encourage innovation and entrepreneurship. They should also dramatically reduce the regulatory burden and other barriers to entry and growth, especially those faced by small and medium-sized businesses. And the federal and provincial governments should increase competition in the domestic economy by reducing interprovincial trade barriers.

For example, the provinces could adopt a policy of “mutual recognition” so the standards and licencing requirements in one province would be accepted by all provinces. Provinces can also unilaterally eliminate self-imposed trade barriers (as Alberta did in 2019 with grazing permits for livestock). Of course, due to resistance from special interest groups that benefit from internal barriers, such reforms will not be easy. But the economic risks to the Canadian economy—from even the threat of a trade war with the U.S.—could generate support among Canadians for these reforms. Indeed, reducing interprovincial barriers to trade and labour mobility might be the single most important thing that governments in Canada could do to improve productivity.

With Canada’s lower inflation rate, weaker labour market and weaker economic growth outlook compared to the U.S., lower interest rates in Canada seem appropriate. Bank of Canada Governor Tiff Macklem wants to see economic activity pick up to absorb slack in the economy and prevent inflation settling below the bank’s 2 per cent target. Clearly, the Bank should focus on inflation and domestic economic conditions. But policymakers must do their part to create a better environment for investment and innovation, the keys to productivity and increased living standards for Canadians.

Steven Globerman

Senior Fellow and Addington Chair in Measurement, Fraser Institute

Lawrence Schembri

Senior Fellow, Fraser Institute