Jean Boivin, the former Bank of Canada deputy governor, was on a video call organized by the Canadian Association of Business Economics a few hours after the central bank issued its conditional pause on interest rate increases this week.

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The timing was a coincidence, as the head of the BlackRock Investment Institute was there to talk about his outlook for the global economy, a contrarian forecast based on the notion that much of what he learned about the economy at Princeton University in the late 1990s has changed.

Boivin thinks inflation will be influenced mostly by supply in the future, which would be an important change from the past few decades, a period during which policymakers and investors were convinced that price pressures were largely a question of demand. That could have all kinds of implications, including on the severity of the slowdown that central banks have just induced to get inflation under control.

The “demand” playbook suggests policymakers will be able to put a floor under the downturn by cutting interest rates. But if Boivin is right, and supply issues are the main drivers of inflation, lower interest rates would only make the inflation problem worse by encouraging more demand than providers of goods and services can satisfy. “We don’t think there will be a soft landing,” he said on Jan. 25.

It’s a big idea. But while talking about it, a miniature change in how the world is supposed to work captured Boivin’s interest: Canada’s central bank has emerged as a trendsetter, not a follower.

Follow the Fed

Boivin recalled that when he was on the Bank of Canada’s leadership team between 2010 and 2012, everyone assumed that all Canadian policymakers did was follow the lead of the United States Federal Reserve. That was a little bit true, but not really. The U.S. and Canadian economies are so interlinked that the monetary policy needed in the bigger economy will also be appropriate for the smaller economy.

And because Canada is a smaller, open economy reliant on trade, there are limits to how wide a gap between interest rates the central bank can tolerate because of the exchange rate: all things equal, a higher benchmark rate in Canada will put upward pressure on the dollar, making exports less competitive; if the reverse happens, a weaker Canadian currency will make imports more expensive, which would encourage inflation.

But the Bank of Canada still has lots of room to set monetary policy to suit what’s happening here, and it’s been asserting its independence from the Fed particularly forcefully over the past year while fighting the most dangerous burst of inflation since the early 1980s.

Governor Tiff Macklem went out on his own in July when he raised the benchmark rate a full percentage point, redefining the “jumbo” moniker that Bay Street and Wall Street had attached to all the outsized rate increases going on around the world as central bankers chased inflation.

This week, with its conditional commitment, the Bank of Canada became the first major central bank to press pause, even though private forecasts have the Fed raising interest rates at least one or two more times. Few think the European Central Bank and the Bank of England are finished either. Down in Australia, inflation is peaking rather than falling, and policymakers might need to raise interest rates by another percentage point to change the trajectory, according to Phil Suttle of Suttle Economics, a research firm based in Washington, D.C.

If Canada’s central bank has looked like a follower for much of its history, then it has the appearance of a leader now. Boivin said the Bank of Canada offered the rest of the rich world a “glimpse” of where monetary policy in their countries is headed.

Indeed, short-term interest rates in the U.S. fell along with Canadian rates, as the Bank of Canada’s conditional hold reinforced views that the Fed is nearing the end of its own campaign against inflation, Karl Schamotta, chief market strategist at Cambridge Mercantile Corp, said in a note to his clients.

The Fed, the ECB and the Bank of England all have interest rate announcements during the week of Jan. 31, and the Bank of Canada’s “surprisingly strong” pivot could pave the way for “more explicit acknowledgement that monetary tightening cycles are nearing completion,” he said.

Pause not pivot

Suttle, whose daily surveys of the global economy tend to focus on the U.S., Europe and Asia, spent part of the day on Jan. 25 thinking about Canada, observing that Macklem’s messaging raised two questions for global investors: how long the Bank of Canada would pause before it started cutting interest rates, and “what does this BoC behaviour suggest for others, most notably the Fed?”

The first question caused Macklem a little consternation. Bond prices already suggested that many investors think he’s going to have to cut interest rates before year-end to offset the economic downturn that everyone — including the Bank of Canada — knows is coming.

By providing such explicit guidance, Macklem risked starting a conversation about a return to lower interest rates that could work against his efforts to convince households and investors he’s serious about crushing inflation with higher rates for an extended period.

“It’s far too early to be talking about cuts,” he told reporters after being asked about Bay Street bets that the benchmark rate would be lower by the fall.

Suttle’s second question was also difficult to answer. Canadian bond prices moved, but the exchange rate was little changed, so it’s unclear if traders truly see the Bank of Canada as a bellwether.

Still, Suttle nudged his readers to check their assumptions on the relationship between Canadian and U.S. monetary policy, observing the Bank of Canada “has been an impressively patient central bank” in the 21st century. The central bank hiked to 4.25 per cent in May 2006 and then left rates unchanged for a year before adding another quarter-point increase; it lifted the benchmark rate to one per cent in September 2010 and left it there for more than four years; and in October 2018, it pushed the policy rate to 1.75 per cent and then moved to the sidelines until the pandemic swept over North America in March 2020.

In the 1980s and 1990s, Canadian rates tended to peak at higher levels than U.S. rates, but that relationship has flipped over the past three hiking cycles. “The BoC stopping at 4.5 per cent and the Fed at 5.13 per cent would thus be more the norm than the outlier,” Suttle wrote, implying that he thinks the Fed will increase its benchmark target rate by another half-point from its current setting of between 4.25 per cent and 4.5 per cent.

The Fed’s next two policy announcements are Feb. 1 and March 22. Canadians probably needn’t watch all that closely.