News and Events
New front in war on strong dollar
October 21st, 2009
The Bank of Canada is pushing back against currency speculators who are driving the dollar to uncomfortable heights and sapping the strength of the economic rebound.
The central bank on Tuesday laid bare to the markets just why Canada might not be such a great short-term bet, a move that knocked back the dollar, at least for now.
Governor Mark Carney used the central bank's latest policy statement to explain that even though an economic recovery is "under way," the dollar's 19-per-cent ascent this year is impeding exporters' ability to participate in a surprisingly strong rebound in global demand.
Mr. Carney and his senior advisers on the Governing Council cut their forecast for economic growth over the next two years, and pushed back by three months their estimate of when inflation will return to the central bank's target, saying slower growth will keep prices increasing less than an annual rate of 2 per cent until the third quarter of 2011.
"Heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures," the Bank of Canada said in a statement.
"The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July."
If the goal was to take some of the steam out of the loonie's ascent, Mr. Carney's latest salvo worked. The currency dropped almost 2 cents to 95.17 cents (U.S.), the lowest since Oct. 8, according to Bank of Canada data.
Investors were reacting to the increased likelihood that the Bank of Canada will follow through on its plan to leave its benchmark interest rate at a record low of 0.25 per cent until June.
From the time that extraordinary pledge was made in April, it has been contingent on the outlook for inflation, which the central bank is mandated by law to keep at an annual rate of 2 per cent over the medium term.
When the Reserve Bank of Australia raised its benchmark interest rate earlier this month, some global investors began to bet that other commodity-based economies, such as Norway and Canada, would follow suit.
That sentiment was putting pressure on the Canadian dollar because investors who fled to the United States for cover during the worst of the financial crisis are now seeking higher yields than can be had in an economy where the benchmark interest rate is expected to remain close to zero well into next year. Under that calculation, any country offering the prospect of higher interest rates makes for an attractive place to park some money.
At a speech on Oct. 8 in Vancouver, Bank of Canada senior deputy governor Paul Jenkins stressed that Canada's and Australia's situations were quite different.
Yesterday, policy makers reinforced that message by emphasizing that the dollar's rise is not only hampering growth, but damping inflation, putting at risk the central bank's efforts to meet its target.
Consumer prices have been weaker than the central bank was expecting, falling at an average annual rate of 0.9 per cent in the third quarter, compared with policy makers' July predication that they would decline at a rate of 0.7 per cent.
Securities tied to investors' expectations of where the Bank of Canada's benchmark overnight target rate is headed tumbled yesterday. The yield on overnight index swaps due in June fell to 0.52 per cent from 0.59 per cent, the steepest decline since April 21, when Mr. Carney cut the benchmark rate to 0.25 per cent and introduced the conditional pledge to leave it there until the middle of next year. The yield on overnight debt swaps is linked to prevailing overnight borrowing rates.
"This did a lot to sever those perceived ties with the [Reserve Bank of Australia]," Stewart Hall, an economist at HSBC Securities in Toronto, said of the Bank of Canada's statement. "The reality is the Bank of Canada will be able to stand by its conditional pledge."
The dollar's rise is making Canadian goods more expensive in the U.S., the country's largest trading partner, and in international markets that tend to price in U.S. dollars. The volatility also complicates planning because with the currency surging at this pace, a contract signed one week is suddenly worth less the next.
That might not be such a problem if Canada had a bigger domestic market.
At home, growth is decent, with the economy getting a lift from low interest rates and government stimulus spending, increased household wealth, improving financial conditions, higher commodity prices and strong business and consumer confidence, the Bank of Canada said.
The problem is that there's a limit to how much Canada's population of 33.7 million people can do to keep a $1.3-trillion economy humming without the wealth generated by exports.
As a result, the central bank left its forecast for economic growth in 2010 at 3 per cent, even though it acknowledged that gross domestic product is currently expanding faster than it had expected. In 2011, policy makers said GDP will increase by 3.3 per cent in 2011, compared with the previous estimate of 3.5 per cent.