The Bank of Canada’s decision last week to lower its policy interest rate by 50 basis points pushes it more than a full percentage point below the U.S. Federal Reserve’s policy rate. The current gap of 130 points will close somewhat if the Fed lowers its rate at its meeting this week but a substantial U.S. premium will remain.

Because borrowing rates tend to follow policy rates, Canadian interest rates will remain well below those in the U.S. for the foreseeable future. This gap will continue to put downward pressure on the Canadian dollar as investors favour higher-earning U.S. dollar-denominated assets over Canadian-dollar assets. President-elect Donald Trump’s threatened trade actions against Canada could also stress the loonie, especially if the Bank of Canada responds with additional rate cuts. On January 1st of this year one U.S. dollar cost C$1.33. At the end of last week that was up to C$1.43 — an already substantial depreciation of 7.6 per cent, with more likely to come.

What effect will a lower loonie have on the Canadian economy? In short, it will increase demand for domestic output and labour and raise import prices, which will all put upward pressure on inflation. 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 this type of physical capital is an important driver of productivity. A declining Canadian dollar makes importing capital equipment more expensive and that discourages investment and therefore slows 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.

If the loonie remains weak against the U.S. dollar and other currencies, it may be more difficult to reverse Canada’s productivity woes and so boost our living standards, which have been declining.  Again in the third quarter, though the economy grew 0.3 per cent, per-person GDP (an indicator of living standards) fell by 0.4 per cent after adjusting for inflation.

Canada also imports technology indirectly, via investments made by U.S.-based companies in their Canadian subsidiaries. A declining C$ does make it cheaper for U.S. companies to buy assets in Canada, but it also reduces the U.S. dollar value of profits American-owned companies earn in Canada. Combined with C$ instability, that may discourage foreign investment and associated technology transfers by increasing the financial uncertainty of such investment.

To be clear, we are not criticizing the Bank of Canada’s decision that hitting its two per cent inflation target requires lower interest rates. But we do think our governments — including the federal government — need to 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. 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 both the federal and provincial governments should increase competition in the domestic economy by reducing interprovincial trade barriers. Provinces could adopt a policy of “mutual recognition” so the standards and licencing requirements in one province would be accepted by all provinces. They could also unilaterally eliminate self-imposed trade barriers (as Alberta did in 2019 with grazing permits for livestock).

Special interest groups that benefit from internal barriers will resist reforms, of course, which means they won’t be easy. But the serious 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 our governments could do to improve productivity.

With Canada’s lower inflation rate, weaker labour market and weaker outlook for economic growth compared to the U.S., lower interest rates in Canada are appropriate. The Bank of Canada’s focus, quite rightly, is on inflation and domestic economic conditions. But policymakers need to do their part to create a better environment for investment and innovation, which are the keys to productivity and rising living standards for Canadians.

Steven Globerman is a senior fellow at the Fraser Institute, as is Lawrence Schembri, former deputy governor of the Bank of Canada.