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The Progressive Economics Forum

Clipping the Loonie’s Wings

Comments in the Bank of Canada’s last two interest-rate announcements and by its Governor have fuelled speculation that it might intervene in currency markets to moderate the overvalued Canadian dollar.

Of course, these remarks may be garnering undue and unintended attention. With the Bank conditionally committed to no interest-rate changes for a year, comments on the dollar have been the only newsworthy item in its most recent couple of interest-rate announcements. Given little room for the usual speculation on what the Bank will do with interest rates, it is hardly surprising that speculation has shifted to what the Bank might do with exchange rates.

Another possibility is that the Bank hoped that simply flagging the loonie’s rise as a problem would scare off enough currency traders to stop this rise. If so, the Bank’s talk does not seem to be working.

When the Bank first complained of “the unprecedentedly rapid rise in the Canadian dollar” on June 4, a loonie bought US$0.91. When the Governor opened the possibility of intervention on July 24, the loonie was worth US$0.92. It has risen to US$0.93 last week and US$0.94 so far today.

Canada’s goods-producing industries buy most of their inputs at Canadian-dollar prices, but sell much of their output at prices denominated in US dollars. The revelation that these industries contracted even more than expected should heighten concern about the loonie’s ascent.

But should the Bank take action? On July 25, The Financial Post printed “Seven reasons why calls for Bank of Canada intervention in the currency market are misguided.” The seven points support two lines of argument: that the loonie is not sufficiently overvalued to warrant intervention and that such intervene would fail anyway.

Is Intervention Needed?

The authors concede that the Canadian dollar is overvalued relative to purchasing power and other benchmarks, but contend that this overvaluation is not large enough to justify intervention.

An obvious retort is that the loonie has appreciated further since July 25. It is presumably more overvalued now than it was then.

More importantly, this question must be answered in a broader economic context. True, the Canadian economy has survived much larger deviations from our dollar’s fundamental value at various times in history.

If Canada’s goods-producing industries were profitable and growing, we might reasonably expect them to cope with a somewhat unfavourable exchange rate without calling for Bank intervention. Indeed, some commentators used to argue that higher Canadian-dollar costs would just help discipline business managers to find greater efficiencies. (As Jim has pointed out, the same “logic” could be used to argue for higher wages or higher taxes on business.)

But today we are in the midst of a severe economic crisis. Because Canadian exporters already have their backs against the wall, the Bank should be less tolerant of an overvalued Canadian dollar.

There is no absolute threshold of overvaluation (or undervaluation) for central-bank intervention. In making this decision, the Bank should assess the exchange rate in the context of wider economic conditions.

Would Intervention Work?

The authors argue that the Bank is too small in the scheme of global currency markets to make a difference. They cite its unsuccessful attempt to support the Canadian dollar in 1998.

However, there is a fundamental difference between trying to raise your currency and trying to lower it. The Bank has finite reserves of foreign currency with which to buy Canadian dollars. When the Bank entered currency markets to strengthen the loonie, currency traders were aware of this limitation.

Conversely, the Bank has unlimited capacity to sell Canadian dollars. It seems reasonable to assume that currency traders would respect this fact if the Bank intervened to weaken the loonie. So, the failure to raise the exchange rate in 1998 does not suggest an inability to lower it today.

A clear result of Japan’s quantitative easing was a weaker yen, which greatly benefited Japanese export industries. Since the Bank of Canada has already unveiled a framework for quantitative easing, printing Canadian dollars for sale in currency markets is a plausible policy option.

UPDATE (August 5): Has Jim Flaherty been reading this blog?

UPDATE (October 16): Quoted by Canadian Press

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Comments

Comment from Saskboy
Time: August 3, 2009, 9:22 pm

We should just print more money, that solves everything…

Comment from Andrew Jackson
Time: August 4, 2009, 5:18 pm

Erin you are absolutely right. There is no symmetry in forex intervention by the central bank between the up side and the down side. Our dollar is over valued and could and should be reigned in.

Comment from Paul Tulloch
Time: August 5, 2009, 1:42 pm

one point that has recently arisen and could help the loonie and its roller coaster ride, is the intervention in the oil markets. There is ample evidence that a good lot of the oil supply is currently owned by trading and speculative entities. The price fixing is undoubtedly systemic is being seriously manipulated through this leverage. We would go a long way here in Canada with our loonie if these forces were reined in.

Serious talk has been perculating through some media channels that the US might consider some sort of regulating power on these speculative forces.

The whole ducth diesease issue is rearing its head again. An economy is such a terrible thing to waste.

By the way, for those aspiring environemental economists, a pretty neat intro course on quantifying many aspects of the environment is currently offerred through the webcast outfit at Berkley. Here is a link, I am on lecture 8 and it does help immensely having many of the co2, nitrogen, water and other aspects straight in ones head when considering economic solutions. THis course under Professor HArte is quite informative and does a great job of it.

Quantitative Aspects of Global Environmental Problems

http://webcast.berkeley.edu/course_details_new.php?seriesid=2009-B-27459&semesterid=2009-B

Comment from Nick Rowe
Time: August 6, 2009, 5:16 pm

Erin: I think you may be right on the symmetry question.

You duck a couple of questions though (though I sympathise with your ducking them; exchange rate theory is difficult enough at the best of times, but at times like these…):

1. Are you talking about sterilised or unsterilised intervention?
2. Would this be a beggar-thy-neigbour depreciation? Because if all Canada’s gains come from merely diverting demand away from other countries, and none from increasing world aggregate demand, the morality is not good, plus it invites other countries to do the same, so we all end up back where we started.

I had a simple-minded go at these two questions over on WCI.

I would prefer QE by printing money and using it to buy something other than foreign currency. If I’m right, it could weaken the Loonie to some extent, but the gain to Canada would not be solely at the expense of other countries. World aggregate demand could expand. And we would be happy if other countries “retaliated”, because that would expand world demand further, and help us all recover more quickly.

Comment from Erin Weir
Time: August 7, 2009, 6:56 am

Nick, I had envisioned what you classify as “unsterilized” intervention (or QE).

I do not see the beggar-thy-neighbour issue as a major concern as long as we are just reducing the loonie to purchasing power parity. However, if we were trying to gain a competitive advantage by fundamentally undervaluing the loonie, then I would worry more about morality and the prospect of US retaliation. By the way, those same concerns should apply to Canada’s current policy of slashing corporate tax rates far below US levels.

Comment from Travis Fast
Time: August 7, 2009, 7:49 am

Indeed any policy designed to encourage regulatory arbitrage can be considered of the beggar-thy-neighbour type.

As an aside, this summer I bought a solar lamp for 2.00 $ Canadian. Package included solar panel, rechargeable battery, LED lamp and all types of different moulded plastic parts and assorted electronics. Works great in rain or shine. Good luck buying all the raw materials (at bulk prices) for two dollars never mind the manufacturing costs.

If one suspects that something less than free trade is ruling the world simply repeat the incantation below five times a day while looking towards the Bank of Canada:

Yea, though I walk through the valley of the shadow of death, I will fear no evil: For Free Trade art with me;

Thy comparative advantage and thy gains from trade, they comfort me.

Thou preparest a table before me in the presence of mine enemies;

Free trade annointest my head with oil; My cup runneth over.

Surely goodness and mercy shall follow me all the days of my life, and I will dwell in the House of Free Trade forever.

Amen!

Comment from Paul Tulloch
Time: August 7, 2009, 6:59 pm

nice travis, liking it, oddly enough I have a poem coming out in the CCPA monitor in septemer, that has a couple lines similar to your prayer, lol.

$2.00 huh, yes it is uncanny ain’t it. PPP, exchange rates, camparative advantage and the whole lot it are absolutely phracked. I recall many long debates with some quantification economists at my old stats barn trying to make sense of it all, and the only thing that seemed to help the understadning was a 25 cent back scratcher.

Comment from Travis Fast
Time: August 11, 2009, 6:37 am

Not really my poem, rather, a modified psalm 23:4. There are some benefits of growing up in Chilliwack BC; it is easy to identify faith based doctrines.

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