By Fergal Smith

TORONTO (Reuters) – The Bank of Canada would be willing to cut interest rates three times ahead of the Federal Reserve’s first move, before a falling currency threatens the inflation outlook, according to the median estimate of seven analysts in a poll.

The weaker Canadian dollar compared to the US dollar this year has sparked debate among investors about how much the BoC would be willing to diverge from its US counterpart.

Investors expect the Canadian central bank to start cutting interest rates in June or July, with next Tuesday’s inflation reading being a key factor. But the Fed may hold off until September, even after Wednesday’s U.S. inflation data was cooler than expected.

The BoC’s benchmark interest rate of 5% is already 38 basis points below the midpoint range set by the Fed for its policy rate. Further widening the differential can augment the pressure on the .

Still, analysts say it would take a enormous currency move to raise import costs, jeopardizing the central bank’s efforts to bring inflation down to its 2% target.

The higher cost of imported goods tends to raise the prices that companies charge consumers.

“While there is a theoretical limit to how much the Bank of Canada can set its own interest rate below the Fed funds rate, it is likely well below current levels,” said Karl Schamotta, chief market strategist at Corpay.

“The exchange rate could weaken if interest rate differentials were to widen further… but the impact of inflation should be relatively moderate.”

The latest data shows inflation was 2.9% annually in March, down from a high of 8.1% in June 2022.

The Canadian dollar has already weakened almost 3% against its U.S. counterpart year to date, to 1.3640 per U.S. dollar, or 73.31 U.S. cents, as the dollar rises against a basket of major currencies.

“Overall, a 10% decline in the currency would result in a 2.5% increase in the price of staples,” Olivia Cross, North America economist at Capital Economics, said in a note, adding that staples make up about 30% of Canada’s CPI basket.

There is a limit to the divergence of U.S. and Canadian interest rates, but “we are certainly not approaching that limit,” Bank of Canada Governor Tiff Macklem said earlier this month.

The Canadian economy has lagged the U.S. economy in recent quarters, weighed down by weaker productivity growth as well as higher household debt levels and a shorter mortgage cycle, which some economists say should put the BoC ahead of the Fed.

The OECD projects Canada’s economy to grow 1% this year, much less than the 2.6% it forecast for the United States.

Since the global financial crisis of 2008–2009, the interest rate gap has remained at 100 basis points. However, that level may not constitute a binding constraint if Canada’s outlook deteriorates in the second half of 2024, said Robert Both, senior macro strategist at TD Securities.

“A larger-than-expected impact on the household sector due to mortgage renewals may give the Bank greater leeway to move away from the Fed,” the pair said.