Bank of Canada Preview

September 9, 2009

The Bank of Canada lowered its overnight money rate target in six steps from 3.0% at the start of October 2008 to 0.25% at its meeting last April 21st, whereupon that level was declared the “effective lower bound.”  A pledge was made at that time that contingent on inflation remaining benign (which it continues to do), the rate target will not be raised before 3Q10.  Plans were made to use quantitative easing if needed, but officials have not exercised that option.  As in many economies, the skies have brightened somewhat after an enormous downpour that saw real GDP drop another 3.4% at an annualized rate in the second quarter and by 3.2% from a year earlier.  June was better than the other months of the second quarter, with factory sales, factory orders, retail sales and wholesale turnover advancing by 1.9%, 18.4%, 1.6% and 0.6%.  Unfortunately, industrial production dropped another 0.6%, constraining growth.  More recent figures for August show a 12.1% rise of housing starts and the best IVEY-PMI score last month (55.7) since July 2008.

Canada’s Achilles heel is the strengthening Canadian dollar, a development that central bank officials have protested often and in strengthening terms this year.  Not too many years ago, Canadian monetary policy was anchored around an index of monetary conditions (MCI), which adjusted changes in three-month commercial paper rates by the concurrent change of the trade-weighted dollar.  Back then, it was assumed that a 3% increase in the trade-weighted Canadian dollar would exert roughly the same effect on growth and inflation as a 100 basis point rise of short-term interest rates.  Policy never reacted mechanistically to changes in the MCI index, but markets behaved as though that would be the case, producing undesirable volatility, and the concept was discarded.  The central bank still publishes a trade-weighted C-dollar index, however, which is more sophisticated than its old measure and known by the acronym of CERI.  That measure is presently 2.4% stronger than when Canadian policymakers last met on July 21, 12.6% above the level on April 21 when the present interest rate level was reached, and 32.1% higher than last October 7, a day before officials cut their target rate to 2.5% from 3.0% in conjunction with easier monetary policies implemented by several other central banks.  By the old rule of thumb, exchange rate appreciation is akin to interest rate rise of about 80 basis points since July 21, 390 basis points since April 21 and 500 basis points since March 3rd.  Clearly, these magnitudes overstate the magnitude of currency-related drag, but even taken with a pinch of salt, CERI’s rise points to a substantial tightening of Canadian monetary conditions since the spring.

With CPI inflation of minus 0.9% versus +3.4% a year ago and with the jobless rate at a 10-1/2 year high of 8.7% versus 6.1% a year ago, ample room exists for Bank of Canada officials to escalate their protest against the Canadian dollar’s climb.  Canada does not have a tradition of massive currency intervention, and no scope remains to cut interest rates.  Quantitative easing juxtaposed against improving economic conditions would be controversial.  There are no obvious responses to take against the problem, which is why the reaction is likely to be of the verbal variety rather than taking concrete actions.

Copyright Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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